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REVERSAL


Divergences And The Housing Index

01/05/05 08:22:46 AM
by David Penn

The first negative divergence led to sideways trading in the housing index. The second? So far, a sharp reversal.

Security:   $HGX
Position:   N/A

A popular putdown in 2003 was to taunt "Who's your daddy?" College basketball fans were chided in the media for taunting a basketball player with a troubled family background with this remark. And baseball pitcher Pedro Martinez, in a strange act of self-deprecation, referred to the rival New York Yankees as "his daddy." Of course, by late 2004, "Who's your daddy?" had gone from mean-spirited taunt to reality show--but then again, what social trend hasn't made that transition in the past 300-odd days?

So, who's the market's daddy? To whom does the market ask "How high?" when told to jump? To whose tune does the market dance? For a while, it appeared that interest rates were the primary candidate for paternity. Then it seemed as if crude oil was in control of stocks. But since the sharp rally that began in October 2004, the only papa I see is the housing market.

Figure 1: The housing index. Has the housing market been calling the tune for the S&P 500? Stochastic divergences in both have been responded to almost identically--first a sideways correction, then a sharper correction.
Graphic provided by: Prophet Financial, Inc.
 
The path that the housing market has traveled over the past several months is fascinatingly similar to the one traveled by the broader stock market--particularly the Standard & Poor's 500. These similarities extend even to the divergences with the 7,10 stochastic--divergences that anticipated a sideways market from mid-November to mid-December, as well as the sharp break in the first few days of January.

As someone who pays a great deal of attention to divergences, I think the action in the housing market has been particularly instructive. Generally, the tendency when encountering a negative divergence is to think that the market in question should not just be sold, but should be sold short. Increasingly, however, it seems like a wiser posture would be to regard negative divergences as creating the opportunity for a short-term bear market--one that might move down sharply (and thus could be profitably sold short), or one that might move sideways as many bear markets do. Suffice it to say that this later type of reaction to a negative divergence often provides a painful experience for short-sellers.

Is there any way to tell the difference, to know whether a given negative divergence is more likely to create a sharp reaction as opposed to a sideways reaction? At this point, I don't believe so. However, as I noted in my latest Working-Money.com article, "Confirming Divergences," there are techniques that can help a trader or investor move from spotting a divergence to profitably trading one. I won't rehash the entirety of that discussion here. But consider the October-November negative stochastic divergence. Even as prices in the $HGX broke down, they never traded below the low of the day that the stochastic made its high.

In other words, a negative divergence is created when the stochastic fails to make a higher high, even as prices do. If the negative divergence is at all sellable, then prices should retreat to at least the low of the day when the higher stochastic high was made. Yes, in the case of $HGX, that would have made for a significant drop; with the stochastic higher low occurring on a day when the low of the $HGX was about 424, the $HGX would have had to fall to at least 386 for the negative divergence to be confirmed.


The December negative divergence was quite a different animal altogether in this regard. Here, all the $HGX needed to do in order to confirm the negative divergence was take out the low of December 15 at 452 and change. This, the $HGX did on an intraday basis on January 4. If there is followthrough to the downside--so as to provide a close below 452--then that should be all that traders require in order to make a reasonable bet that the $HGX is headed lower. Should that be the case, likely levels of near-term support loom between the 430/420 area--the range of the sideways bear market anticipated by the previous October-November negative stochastic divergence.



David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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