Recent Dow Momentum Divergence Resolved

Mar 5, 2007: 10:29 PM CST

Did the most recent stock market decline come as a surprise to you?

My guess is yes, and to be honest, its violence and rapidness came as a surprise to me – but I had been sensing things just weren’t right with the market for some time. Unfortunately, this intuition kept me sidelines and missing out on profits to be realized to the long-side as I kept anticipating a market correction (never to the magnitude we’ve just experienced, and not so quickly) but I did want to point out the reason for my skepticism (other than my natural skepticism).

I follow momentum indicators and typically try to play short gains when I (think) I spot a momentum divergence forming. I actually tried playing some of the recent index divergences to the short side, only to be stopped out and frustrated when the market would reverse. I kept focusing on the intraday frames recently as the market kept rallying then countertrending/correcting then rallying, all in a creeping, oozing trend. Also note the trend-trading tactics which could have been employed as the market retraced frequently back to the rising 20 period moving average (these served as new entry points).

I did want to point out something interesting I just noticed with the recent action. First, let me point out the gross momentum divergence that was appearing in almost any oscillator indicator you use. I am using StockChart’s graph and showing RSI (at the top) and MACD (bottom). Note the divergent direction of the indicators with the (creeping) upwards price action.

Please pardon all the lines I’ve annotated, as I’m sure you can see the building divergences yourself, but I wanted to highlight the swing highs in price and their relation with the two momentum indicators.

Imagine the momentum divergences as a coiled spring. The longer they go unresolved, the sharper (harder) the resolution (release of pressure) will be when pressure is released. Typical divergences resolve after a simple two point occurrence (between two swing highs) yet this continued longer than I anticipated.

I had been out of the market for longer term trades since the beginning of this year in anticipation of the release of the three-point divergence I observed, which carried over for an additional two months before the final resolution recently. My family and friends kept yelling at me for “missing opportunities and leaving money on the table!” I couldn’t properly explain that something was wrong with the market – it was a gut thing. The market wasn’t “swinging” (retracing/correcting) as it should be. Typical swings and volitility were contracting too much for my comfort. Typically, expansion occurs after volatility contraction, and we just experienced that in a big way (as fear/panic drive stock prices lower faster than greed drives them higher).

What was shocking to me – and will lead me to examine more market data – is that the price corrected the divergence exactly (and now beyond) where the divergence initially began – in this case around 12,100 on on the Dow (late October, 2006). This piques my interest and I will begin examining whether divergence targets test out to resolve back to the initial point of divergence. I hope to have this analysis in the next few weeks.

In the meantime, play it safe out there, enjoy the recent bout of volatility we are experiencing, and show courage in the face of this newly awakened market.

(Note: The same momentum divergences can be observed on the S&P 500 and the NASDAQ).

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