Smoothed Breadth and Market Dead Air – Internal Divergences

Oct 12, 2010: 12:39 PM CST

Anyone who knows me knows how big a fan I am of “Market Internal” divergences (or momentum divergences as well).

They’re one of my favorite methods of market analysis, as they seek to reveal the health – or weakness – of a trend in progress.

Divergences often appear ahead of big turns in price, and the last few months have certainly been no exception of that rule.

Let’s take a look back at the prior two major Breadth divergences (and subsequent reversals) and then look at what breadth says right now.

First, let me explain the indicators.

Instead of showing actual Breadth ($ADD) or Volume Difference (of Breadth) – $VOLD, what I’ve done on the daily frame is smooth them both out with a 20 period simple moving average.

You can use a 10 day SMA – same logic – but the point is to smooth out the volatility and arrive at a clearer picture of what’s going on under the market’s hood.

Let’s start with prior divergences.

1.  APRIL/MAY DEATH RALLY

Ok, I’m sensationalizing the terminology, but that’s really what it was to those trading it.

It was a situation where Breadth, Volume, and Momentum declined almost every day as the market rose every single day.

You couldn’t really get short, as there was no trigger (you can’t trade short off a divergence – you need price to break a trendline for entry), and you really couldn’t get long because at any day, the market could ‘fall apart’ due to the lengthy non-confirmation… which was exactly what happened.

Anyway, this was a great lesson in how divergences undercut a rally in progress, but just because divergences exist does not mean the market will collapse the very next day.  Price often rallies longer than most people think it will.

The main idea is that trading long in an environment of lengthy, massive divergences (such as April/May) is extremely risky and similar to playing Musical Chairs where the music will stop – those caught without a chair will suffer.

It’s also like walking farther out into a frozen lake where the ice is becoming weaker under your feet – the longer you walk and ignore the danger of the ice cracking under your feet, the more danger you’re in.

Anyway – the April/May divergence period was one of the worst I can remember seeing – and it ended appropriately and exactly as expected – with a Crash, not a thud.  We now call this the “Flash Crash” but divergences suggested at the potential of a devastating crash the longer the market rose on daily declining ‘internals.’

2.  JULY POSITIVE DIVERGENCE AT LOWS

Markets are more likely to “Crash” down than they are to “crash” up, particularly when forming a bottom (in other words, you’re more likely to see huge, single down days than you are to see huge single up-days).

As the S&P 500 pushed to new 2010 lows at the 1,010 level in July, internals (Breadth and Momentum particularly) showed POSITIVE divergences.

Price formed a key (visible) LOWER low while internals (and momentum) formed a HIGHER indicator low – locking in a positive divergence.

The positive divergence preceded a short-term reversal that took the market back to 1,130… where a negative divergence (not really captured by the smoothed 20 day average) sent the market back down.

3.  SEPTEMBER/OCTOBER RALLY

That brings us to the present, where the situation is looking similar to the April/May period, but if that’s the case, we’re somewhere in the late-middle period of a grossly overextended rally that is showing consistently weaker momentum and internal support.

In the charts above, I highlighted areas where Breadth peaked and then – in the case of April/May – labeled the resulting higher price action as “Dead Air” which is a good way to visualize it.

It’s like a tree that looks strong from the outside, but internally is decaying.

And if we take the recent past and apply it to the present, we can suspect that price CAN continue rising higher and higher, but the longer it does so WITHOUT the support of momentum and internals actually increases the probability of a severe pullback/reversal – as opposed to a gentle retracement.

What’s remarkable is that just before the actual May Flash Crash (May 6th), the 20 day SMA of Breadth almost turned negative (zero-line).

We’re seeing the current 20 day SMA of breadth nearing the zero-line again as price pushes higher and higher.

I won’t extrapolate any more beyond that, but it goes without saying that you should probably be more cautious to the long-side, even though we could certainly see higher prices yet to come – especially if the market breaks above 1,170 and travels back to the 1,200/1,220 region.

If volume, momentum, and breadth do NOT increase as price subsequently rises… look out for a much sharper correction to come that would correspond with the Bullish “Music” stopping.

Corey Rosenbloom, CMT
Afraid to Trade.com

Follow Corey on Twitter:  http://twitter.com/afraidtotrade

11 Comments

11 Responses to “Smoothed Breadth and Market Dead Air – Internal Divergences”

  1. Corey Rosenbloom, CMT Says:

    Oh – and as a footnote, the moving average is a calculation of highs, lows, and closes instead of your standard “close only” average.

    The function is ” (high + low + close) / 3 “

    Average the high, low, and close basically.

  2. arkhamb Says:

    Thanks for the blog…read it every day.

    Always read about divergences with indicators, but couldn't it be said that just means they're less than effective. In your chart with the first “peak”, there was 50-60 points upside from when the indicators started downward “ahead” of the price downturn. Wouldn't it be more profitable just to ride it to the top, then get out on a 30 pt fall in price? Then you are about 30 points richer, at least in the April example. I understand most traders, aren't holding ES longs for extended periods of time, but for arguments sake lets say they are, or at least their holdings are performing similar to ES.

  3. J123 Says:

    Besides Tradestation, any platforms you'd recommend for plotting $ADD and $VOLD?

  4. S&P 500 « Vibetrader's Blog Says:

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  5. Corey Rosenbloom, CMT Says:

    I'm most familiar with TS and StockCharts , and in Stockcharts, the corresponding symbols would be $NYAD and $NYUD. Check the tutorials or symbol listing of other platforms/software, or if fellow readers want to share here in the comments, please do so.

  6. Corey Rosenbloom, CMT Says:

    Thanks Arkhamb!

    That's a discussion I've had privately with a few traders. The answer is that the ultimate choice rests with you/individual trader and there's no concrete answer.

    That's because in conditions of stretched divergences, odds increase for a pullback (increase, but don't guarantee) so each day you remained stretched is like walking a step further out on the ice. Will you fall in? I guess it could be said that you're picking up dollars on the ground as you walk closer to the center of a pond. Will the ice break? Is it worth the risk of picking up dollars in the event that you fall in?

    Or is it worth making $200 or $300 per day only to wake up to a one-day loss of $2,000 or $3,000 and a 'deer in the headlights' panic that keeps you long which then morphs into a $5,000 or $8,000 loss?

    Remember, it's all perfect in hindsight but in real time, some traders caught long panicked and sold at the 1,040 level or lower after the crash. We'd like to think we wouldn't do that, but we might.

    Anyway – it's all about risk and opportunity. The Black Swan (Taleb) is a good reference for this. Do you collect small profits every day but be exposed to a career ending loss (massive divergences and the sudden resolution) or do you wait on the sideline neutral… or do you stay short despite losing a few hundred dollars a day in the anticipation of a string of thousand dollar days?

    Very thought provoking.

  7. Chabazite Says:

    I have been following your site for some time now Corey. I am based in England but since there is a close correlation between the FTSE100 and the S&P I find your posts highly relevant. For what its worth I too have been drawing similar conclusions using the 14 day SMA of the $NYAD. The picture is very similar to that of mid-April with a stalled decline. One cannot help but sense it is just a matter of time. The vultures are circling!

  8. Guest Says:

    Corey, It happened once (panic). It doesn't mean it happens every time. It is risky but stocks mean risky anyway. May be it is good to cut the positions when we see such data.

  9. Teich50 Says:

    Try this free link:

    http://stockcharts.com/h-sc/ui?s=$NYAD&p=D&b=5&g=0&id=p83139155480

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