ANALYZING DIVERGENCES - PPO DIVERGENCES FORM IN IWM AND SPY - RSI BECOMES OVERBOUGHT FOR QQQQ - GAS AND INTEREST RATES CONTINUE TO RISE - REGIONAL BANK ETF SHOWS RELATIVE WEAKNESS
DISSECTING DIVERGENCES ... There are some negative divergences to report, but first lets review the definition and look at some prior signals. A negative divergence occurs when the underlying security moves to a new high, but the indicator fails to exceed its prior high. This lower high in the indicator signals that upside momentum was not as strong as on the prior move. Waning upside momentum sometimes foreshadows a trend reversal or a pullback, but not all negative divergences produce good signals.
Chart 1 shows the S&P 500 ETF (SPY) with the Percentage Price Oscillator (PPO) from July 2006 until March 2007. The blue arrows show when the PPO formed a negative divergence and moved below its signal line. Admittedly, the first divergence (Sep-06) was ever so slight, but the other three were quite pronounced (Nov-06, Dec-06 and Jan-07). Despite waning upside momentum, SPY continued to new highs after each divergence. Shorting SPY or turning bearish based on these divergences would have resulted in numerous whipsaws (loosing trades). Even though upside momentum was declining, upside momentum was still stronger than downside momentum as long as the PPO remained in positive territory. Downside momentum does not take over until the PPO moves below zero, which it finally did in late February 2007.
Chart 1
Now lets look at some good signals. Chart 2 shows SPY with a positive divergence that produced a great signal in March 2008 and a negative divergence that produced an equally good signal in May 2008. The January-March positive divergence was quite large, but the May negative divergence was small. Even so, it foreshadowed a sharp decline into mid July. Notice that the PPO moved below its signal line in late May, turned negative in early June and stayed below its signal line throughout June. As its name implies, the signal line can be used for timing purposes.
Chart 2
SMALL NEGATIVE DIVERGENCE IN SPY AND IWM... Both the S&P 500 ETF (SPY) and the Russell 2000 ETF (IWM) have small negative divergences working in two momentum oscillators, RSI and the PPO. Just because two momentum oscillators confirm one another does not make the signal more robust. After all, momentum oscillators measure the same thing, momentum. With that in mind, I am going to focus on the PPO. Chart 3 shows SPY moving above its May high in June. Despite a breakout and higher high in the ETF, the PPO did not come close to its May high and formed a negative divergence over the last five weeks. Because SPY closed well above its intraday low, the PPO did not move below its signal line today. Chart 4 shows the Russell 2000 ETF (IWM) with similar characteristics.
Chart 3
Chart 4
QQQQ TURNS OVERBOUGHT... In addition to the negative divergence mentioned above, the Nasdaq 100 ETF (QQQQ) became overbought as it surged above 36.5 in June. Chart 5 shows 14-period RSI moving above 70 in early May and again in early June. Overbought is a sign of strength because strong securities become overbought, not weak ones. However, overbought readings also raise the yellow flag. With a clear uptrend underway, this overbought reading indicates that prices have perhaps moved too far too fast. From the bottom of the consolidation to the recent high, QQQQ surged over 10% (~33 to ~37). On the price chart, the pennant breakout remains in play and should be considered bullish until proven otherwise. Broken resistance around 35 turns into the first support zone to watch. A strong breakout should hold and a sharp decline below 35 would warrant a reassessment. This same logic can be applied to recent breakouts for DIA, IWM and SPY.
Chart 5
GAS AND INTEREST RATES ARE GETTING UP THERE... Although not exactly related, the US Gasoline Fund ETF (UGA) and the 10-Year Treasury Yield ($TNX) remain on a steady march north. It is amazing how similar these charts look. Chart 6 shows the 10-year Yield hitting 4% on its high today, which is the highest level since September-October. This is a huge move from the December low of 2.038%. Similarly, chart 7 shows the US Gasoline Fund ETF marching higher since late December. From a low of 16.10 in December, UGA reached 34.08 on its high today. Thats almost a 100% gain in less than seven months. The steady rise in interest rates, gasoline prices and oil has yet to spook the stock market, but it is something to keep in mind going forward, especially with QQQQ overbought and momentum waning for SPY and IWM.
Chart 6
Chart 7
REGIONAL BANKS LAGGING... Relative weakness in the Regional Bank SPDR (KRE) presents another potentially negative development. While SPY is trading above its May highs, KRE is not even close and seriously underperforming the market. Chart 8 shows the price relative moving below its March low over the last few weeks. On the price chart, the ETF established support at 19 in April and reinforced this support level with a bounce in May. However, that bounce took the shape of a rising wedge and the ETF broke the lower trendline today. The combination of relative weakness and the wedge break is bearish for this key industry group ETF.
Chart 8
