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  • Writer's pictureEdward Ballsdon

S&P 500 - MOMENTUM DIVERGENCE

Updated: Jul 18




Financial markets never go somewhere in a straight line. Many things impact changes to a financial instrument’s asset price, for example a relative or absolute change in expectations about the underlying “value” of the asset, the P&L embedded in a position or the liability against which an asset is purchased.


A change in investor sentiment can quite simply be detected by analysing a financial instrument’s price action (ignoring any “market news”), studying price patterns or the underlying price trend momentum. The danger of course is that an analysis is completed whereby the conclusion is what the observer wants to find, ignoring other opposing clear signals. To this end, drawing lines on a price chart (rather than a momentum chart) is seen as one of the quickest ways to confirm a bias, leading to poor trades and investments. For example, over the years this has been the case for Government Bond bears, who have interpreted a pause in the long term yield decline as a confirmation that rates would rise back up. The same goes for equity bears who have seen corrections as the beginning of something much deeper.


PRICE MOMENTUM


One of the most reliable signals that a change in the medium term price trend has occurred is when there is a change to the trend of the Relative Strength Index on a weekly chart (past examples in the Appendix). Whilst the absolute level of the RSI tells you about the strength of market sentiment (>70 Bullish, ~50 Neutral, <30 Bearish), the change in the RSI trend warns about a significant change to that sentiment and thus a potential change in PRICE trend. Below shows an example for Oil, highlighting the change in RSI and the change in price trends.



The RSI change of trend is a good signalling effect, and it is strengthened when it is also accompanied by a


  • “trend reversal price pattern” that confirms that the previous trend is extinguished (e.g. Bullish/Bearish Engulfing, Bullish/Bearish Star etc) and

  • a break of a key moving average.


There is another key flag that comes from the RSI – a “Divergence” Signal (pink above). This occurs when the price makes a new high (or new low) but with a lower bullish (bearish) momentum – i.e. with an RSI reading that is below the RSI reading at the previous price peak. This is an indication that at the new price highs, the buying power is less strong. This could be because there are less buyers (volumes will be lower in this case) and/or because buyers are now being met by sellers (volumes remain normal). A divergence signal is a warning flag that everything is priced into an asset, and there is a risk of profit taking by those with profit.


DRIVERS OF THE S&P 500 REBOUND


There have been numerous articles discussing the surprising speed and strength of the S&P rebound after the sharp selloff, given the terrible economic data and impact of the Covid19 pandemic on corporates. Likewise, there are discussions about the different impacts of solvency vs liquidity aid to asset price valuations. Furthermore there are plenty of reports about retail involvement in driving prices higher as well as some extraordinary charts showing how the index has made nearly all of its gains outside of US trading hours.

Beyond all of these arguments, the biggest issue that really sticks out is just how poor the breadth of the rebound is, with the S&P relying on just a handful of stocks for its strong rebound. This can be seen in a note published yesterday by Albert Edwards – two of his standout charts show the relative performance of the top 5 and 10 stocks to the overall S&P index, and the subsequent performance when this has happened in the past.

He then highlights work by Gerard Minack (DOD) which depicts how an S&P 494, which excludes the 6 strong stocks (FAAANM), has returned similar returns to a Rest of World Index, which is also in line with profitability.


RSI DIVERGENCE FORMING ON FAAANM?


If the S&P 500 rally has been so reliant on 6 stocks, then understanding the health of those individual 6 trends must be key to understand the overall S&P Bull trend. To this end, below is the weekly candle chart, for a weighted FAAANM basket, together with its RSI.


It is clear that although the rebound has been strong for this FAAANM Index, with the price making new highs, bullish momentum remains low relative to the February price peak, in large part due to the March sell off. IF, and it’s a big if at this moment in time, the price stabilises and remains at these levels, then momentum will fall further, leading to the formation of a Divergence signal. Given the large profits on long positions and current valuations against future profits (see Edwards’s and Minack’s pieces), it would be entirely justified to see a wave of profit taking, taking prices lower.

(FAAAM = FB, AAPL, AMZN, GOOGL, NFLX, MSFT)

The charts below show that momentum on the individual 6 stocks is quite similar, as price gains have occurred with a less strong RSI. However, there are small and potentially important differences between the stocks.


  1. The increase in price momentum for Facebook, Microsoft and Amazon (largest weight) has come to a stop, which could be temporary in nature. However, if the RSI was to drop, then a lower high in the RSI would be formed and a Divergence signal would be formed, signifying that market sentiment was no longer Bullish.

  2. The RSI in Netflix remains on a positive trend of higher highs and higher lows. A correction of the RSI below this trend would signal a warning of a deeper price correction (as occurred in 2018, which brought deep losses).

  3. Although the rise in both Alphabet and Apple stock prices have risen with a relatively low RSI compared to the previous RSI peak in February, neither RSI has yet to show a potential for peaking.

ANOTHER WARNING SIGNAL


The MACD trend following momentum indicator is giving a similar message. On the daily FAAANM Index chart (left), the black MACD line has turned down and crossed below the Red Signal line, as it has for Amazon, Microsoft, Apple and Netflix stocks, suggesting lower prices ahead. However, the weekly charts still show the MACD line well above the Signal line, but the distance between them has decreased. Any further decrease would suggest declining medium term bullish momentum.


CONCLUSION


The bafflement of the S&P500 rebound can be explained by the strong performance of only a handful of stocks. Such instances of poor breadth in the past have not led to a good future performance for those stocks.


Current momentum indicators are potentially flagging a “Divergence” between rising prices against a decline in bullish sentiment. This is a warning that buyer vs. seller dynamics are changing.


If there is a Divergence being formed, then the market should expect “sellers on strength” to dominate, which should come as no surprise given the profits embedded in positions AND what is already priced into the market.


These are weekly, not daily charts. A follow through from a divergence on a weekly chart would indicate a deeper correction than just a simple retracement of a bull trend.

The signals seem most obvious for Facebook, Microsoft and Amazon, the latter the most important given its heavy weight in the index. IF a weekly lower low is formed on the RSI of these three stocks, then they would most probably lead to losses on the others and the S&P500 more broadly.

 

APPENDIX – Past examples of Market Commentary on RSI Warning Signals.


Below are excerpts from previous market commentaries which demonstrate how Divergence signals warn of changes to trends BEFORE they take place (NB, Hat Tip to Mario and Luciano for teaching me this 20 odd years ago!). Full commentary available upon request.

1) Sep18, Warning for OIL and Equity before the 4Q sell off:

2) Oct 18, Warning for SX5E and Oil


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