Traders are always looking for indications as to what the market will be doing in the near to medium term. A leading indicator is divergence, in which the price of the share or index moves away from an indicator, signaling a trend reversal.
However the problem with divergence is that it is not good at timing signals, as it could last for months before the markets get back in sync. When markets reach a tipping point, the longer term investors are often the last to know, as we’ve seen recently within the silver market.
The US markets may well be nearing such a tipping point. The S&P 500 index has had a negative start to May following a strong April, and this marks the first time the index has declined over the first three trading sessions of a month since October 2008. We also see that commodities prices have recently been hit across the board with crude oil, gold and silver prices all down. Silver prices are down 28 percent in just seven trading sessions. Another catalyst could be the market’s reaction to the impending end of the US Federal Reserve’s $600 billion asset-purchase program (QE2) in June.
The savvy trader seeks clues of some early warning of a market turnaround, and there are some key market segments and inter-relationships that can be helpful in pointing to a turnaround.
The US Markets
The US markets have had a great run since the end of the GFC in early 2009, however the S&P 500 index had a negative start to March, which marks the first time the index has declined over the first 3 trading sessions of a month since October 2008 and this could be pointing to a change in investor sentiment.
Divergence has appeared, as shown in the chart below. The momentum technical indicator for the S&P 500, which tracks the rate of change, has been showing negative divergence over the past few months.
This divergence, along with a number of divergences as discussed below, could be signalling warning bells.
Silver Price Turnaround
The recent turnaround in the silver market shows what can happen when a divergence signal works.
Divergence appeared (as shown in the chart below) with the momentum technical indicator. Negative divergence developed in the last few days of April.
Divergence can work spectacularly, as shown with the silver market. The fantastic run of silver was splashed across the press last week, but silver prices have since plunged 28 percent in the past seven trading sessions.
Inter-Market Divergence
Divergence can develop between inter-related markets. Commodities prices have pulled back from record levels recently and the commodities markets influence the equities markets.
The charts below show that divergence signals have developed between copper and the S&P 500 on a number of occasions over the past couple of years, with the copper price leading the equities markets in early 2009 and mid-2010.
Copper is the key metal used by the manufacturing and construction industries and its fortunes are therefore closely tied to the equities markets. Divergence has again developed between copper and the S&P 500. Copper prices have been in steady decline over the last few months with copper futures falling 11% since settling at an all-time high in mid-February. Copper prices are now down 7% year-to-date, while the S&P 500 is still above its February high and is up 7.1% year to date. If history repeats itself, then the S&P 500 equities are setting up for a fall.
The Aussie Market
The Aussie market is tied closely to the fortunes of the commodities markets and has been under-performing the US markets, as shown in the charts below. It is good to note that in real terms the US markets have really under-performed Australia because their gains have been driven by the weakness in the US dollar.
The divergences between copper prices and the Aussie market have also resulted in our equities prices following the lead of the copper price, and we too are setting up divergence in the current market.
The Trade
There are a number of indicators showing divergence, which could be a warning that markets are setting up for a turnaround. The sell-off in the silver market shows what can happen when markets get ahead of themselves.
If copper prices continue to decline then equities may be in trouble, and another catalyst could be the market’s reaction to the impending end of the US Federal Reserve’s $600 billion asset-purchase program (QE2) in June.
By Michael Hevern
Head of Research
MDS Financial Research
MDS Financial Research monitors the market daily and highlights trading stocks when they are ready to run. Sign-up for a 14-day trial today.
Market Analyser Software Trial
The Market Analyser software provides you with access to the charts above using the following codes: S&P 500 [.GSPC], ASX S&P 200 [.AXJO], Copper [HGc1] and Silver [SIc1].
You can sign up for a free trial of Market Analyser Gold, or for more information take a tour of the software.
