Bulls Jump Up To Get Beat Down

02/22/05 07:48:13 AM

by David Penn

Muddled positive divergences in many averages launched rallies in late January. Will clear-cut negative divergences mark the end of those rallies?

Security: $SPX
Position: N/A

One of my favorite mixed-martial artists has a catchphrase he uses to describe his victories: "Punks jump up to get beat down." I heard this fighter, Yves Edwards, make the remark again recently in an interview about one of his dramatic knockout wins, but -- with my ears on the interview but my eyes on the S&P 500 -- it almost seemed to me as if the young, mild-mannered Texan (who calls his fighting style "thugjitsu") might have been describing the market action as well.

I don't know if there are too many better ways to describe the sense you get when you see a market that has been rising on declining volume suddenly develop a clear-cut negative stochastic divergence. While it remains true, as I have pointed out before, that negative stochastic divergences do not guarantee reversals, they can be a powerful warning that the odds have shifted against the trend -- and that more protrend action is desperately needed to stave off a reversal.

Figure 1: S&P 500. Multiple negative stochastic divergences abound as the rally that began in late January extends into mid-February.

Graphic provided by: Prophet Financial, Inc.

Early in bull markets, this kind of protrend action or protrend followthrough is relatively easy to come by. However, in markets that are extended, or in markets that have recently suffered a sharp decline, the negative divergences that can arise are particularly worth paying attention to. What's more, careful entry planning can often keep a trader out of a potential divergence-related reversal until that reversal shows it is truly ready to roll.

The negative stochastic divergences casting a shadow of the January-to-February rallies in most averages are too prominent to be ignored. In the case of the Standard & Poor's 500, there are a pair of negative stochastic divergences that stick out. The first negative stochastic divergence arrived with the pair of February highs on February 2 and 8. Unfortunately for S&P 500 bears, there was not nearly enough followthrough to the downside after February 8 to turn that negative stochastic divergence into a winning short trade. In fact, for all intents and purposes, the low of February 8 held.

Thursday's trading in the S&P 500 produced another negative stochastic divergence as prices made a higher high for the month while the stochastic made a lower high -- actually, the second lower high since February 2. Thursday's trading also saw the S&P 500 plow through the lower support boundary of its bullish January-February trend channel. Followthrough to the downside below 1200 is an absolute minimum for Thursday's bearishness to result in a real reversal. But it might take a print closer to 1195.50 before the bearish beatdown is truly under way.

David Penn

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

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