Thursday, June 21, 2007

Divergences













I wanted to touch on a subject which I think is under appreciated and underutilized. As you can tell I am trying to satisfy the frustrated English major in me with some multiple syllable words, but that's a completely different story. Basically what we are looking for with divergences is similar to what a detective would be looking for in solving a crime, such as inconsistencies, contradictions and breaks with the norm(assuming we know what normal is). As you know I consider price and volume paramount in my decision making, all else is fluff. It helps that I have been fooled and duped into believing so many other indicators in the past that have led me astray more ofter than I care to relive. If you still don't believe me on this then just try explaining to your margin clerk after a margin call that the MacD or RSI is positively diverging, as the position continues to crater. Odds are you will hear uncontrolled laughter on the other end unless, that is, you are the Bear Stearns Toxic Crap Hyper leveraged fund but I covered that one already. What we want to be on the lookout for is things that should be happening given a technical circumstance but are or are not. Speaking of MacD and RSI you can watch these momentum indicators for positive divergences, they are making higher lows when price is not and vice versa. These can be clues that a trend reversal may be at hand. A breakout thru clear resistance which reverses with little follow thru. Imagine you are going on a long trip with young children, and a couple of days before you leave your car hiccups and stutters while driving, no biggie you think to yourself, you're in a rush and you brush it off. Big mistake, as the odds are there is a problem somewhere in the system and it will rear its head at the worst possible time and you will curse yourself for being so stupid to ignore it. Well, same thing in the tape action of the stock, just because the tape did this doesn't mean you need to panic but you need to be paying higher attention.


I mentioned in an earlier post how closely I follow Merrill Lynch as I believe it leads the market and is one of my favorite indicators. Well we have what I feel is a serious negative divergence going on currently with MER and the overall market as Merrill has failed to better its old highs even as the overall market has. Many would point to this as inherent strength where I would politely disagree and counter that this is in fact a major contradiction or inconsistency. The bulls always want it both ways and you will never change their mind but our job is not to be on the bull or bear side but the right side! If you look at a daily chart of the Dow (top left) you see as the Dow tested its early June highs last week we can see the negative divergences occurring with RSI and MACD as it did. If you now compare the Dow action with the Merrill daily chart(top right) you can see Merrill failing at a lower high and now turning down. This what I would call a good example of negative divergence or put another way non-confirmation. As I am writing this Merrill broke its early June low of $87.07 which is not a good sign for the bulls. I am long the Ultrashort Financials (SKF) to play this breakdown.
Before I go I wanted to touch on the Bear Stearns thing again. I think the thing to take away from the Bear, Merrill situation is that Merrill is auctioning off about 100 mill of about 850 mill. What this means is that a very illiquid non-quoted market now will have some recent pricing and this could have some extremely serious repercussions across the sub-prime alt -A spectrum. I have no inside details but sometimes all it takes is one domino. Complacency is extremely high as all sell offs are viewed as buying opportunities and the bulls are really emboldened. Everyone on the street knows the sub prime stuff is crap but as long as no one upsets the status quo everyone keeps collecting mangement fees for doing jack and praying nothing upsets this fairy tale. Remember, he who panics first panics best. I think the bond market smells trouble and is selling bonds, raising rates to compensate for risk. Yes, I mean to remind you that the word still does exist. Good luck and good trading to you.








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