Small Caps Still Bullish

07/31/03 10:10:00 AM

by Arthur Hill

Despite a bearish divergence in MACD, the S&P SmallCap Index remains in a strong uptrend that has yet to be proven otherwise. What would it take to prove otherwise?

Security: SML
Position: N/A

First, let's look at the bullish divergence in MACD that foreshadowed the March low. For this momentum indicator (MACD), there were three steps to bullish confirmation. First, the bullish divergence (higher low) shows that the decline is losing momentum (green arrow). Second, the signal line crossover shows that MACD is actually advancing. Third, the move above zero turns momentum from negative to positive (gray line). The opposite would apply to confirm a bearish divergence. As MACD now stands, the indicator has a bearish divergence and signal line crossover, but remains well above the zero line. This indicates that upside momentum is slowing, but momentum still favors the bulls as long as MACD remains above zero.

Graphic provided by: MetaStock.

Now let's look at the price chart to see how SML confirmed the (MACD) bullish divergence in March. For a trend change, there are three items to consider. First, a trendline break shows that prices are actually reversing their downward trajectory. Second, a higher reaction low shows that selling pressure is diminishing. Third, and most important, a higher high or resistance break shows that buying pressure is increasing. Although the trendline extending down from January 2003 was tentative (two touches), SML broke above with a strong move. A higher low did not form, but the index did exceed resistance at 186 and confirm MACD. In addition, MACD moved into positive territory at this time.

The current uptrend for SML has yet to be proven otherwise, but it would not take much to tilt the balance in favor of the bears. First, the index is holding above the trendline extending up from April. This trendline has been touched at least three times and should be considered valid. Second, SML has yet to exceed its July high and could be forming a lower high, indicating less buying pressure. Third, and most important, resistance-turned-support at 224 represents an important level. A move below 224 would break the trendline, confirm the lower high and forge a lower low. All three ingredients for a trend change would then be in place and the bearish divergence in MACD would be firmly confirmed. Until the missing pieces fall into place, it would be wise to show some respect for the uptrend.

Arthur Hill

Arthur Hill is currently editor of TDTrader.com, a website specializing in trading strategies, sector/industry specific breadth stats and overall technical analysis. He passed the Society of Technical Analysts (STA London) diploma exam with distinction is a Certified Financial Technician (CFTe). Prior to TD Trader, he was the Chief Technical Analyst for Stockcharts.com and the main contributor to the ChartSchool.

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