November Divergences

11/29/05 11:15:15 AM

by David Penn

Do the looming negative divergences in semiconductor stocks make for a buying opportunity?

Security: $NYA, SMH
Position: N/A

Traders, speculators, and investors can be forgiven for the acute sense of deja vu they must be experiencing in November 2005. After all, didn't the market end a bearish streak in October last year, turning on a dime and soaring higher over the course of the following month?

Different years and different rallies have emerged out of different bearish conditions, but the potential for a happy ending is palpable among investors. In some ways, it appears as if a perfect storm of short-covering and seasonality has done for 2005 what the prospect of a referendum on national political leadership did in 2004. Given the gale force of October lows that weren't nearly as low as some expected and the combination of the pre-Thanksgiving week, end-of-the-month window dressing, and the hopes of retailers springing eternal as the December holiday season nears (see Figure 1), what bear in his or her right mind would have tried spitting into THAT wind?

FIGURE 1: NYSE, DAILY. A happy ending for 2004 revealed itself as stocks rallied from a mild October correction to make new highs for the year in November and December.

Graphic provided by: Prophet Financial, Inc.

"That wind" has brought the major stock indexes to or near multiyear highs in the autumn of 2005 -- a feat that would have seemed virtually impossible a little over a year ago, when stocks were mired in the bear market of the first half of 2004. But to the consternation of bears and underinvested bulls, what goes up often continues to go up. And the autumn rally of 2005 has shown little inclination to pause in order to let these latecomers on board without paying a premium on the fare.

FIGURE 2: HOLDRS, DAILY SEMICONDUCTOR. Negative divergences developed in both the MACD histogram and the stochastic in late 2005 as the SMH approached potential resistance at the October and September highs.

Graphic provided by: Prophet Financial, Inc.

Or have those inclinations changed? However it has been expected, the post-holiday stall in the markets has many speculators wondering whether the pause they have been hoping for has arrived, to say nothing of a more meaningful pullback that might make bargains out of merchandise that not too long ago only seemed capable of increasing in value. While the strength of the preceding rally has precious few daring to utter the "T" word (that is, "top"), objective observers are wondering just how much of a correction the markets will pursue and, more important, what sort of buying opportunity might lie on the other side.

The chart of the semiconductor HOLDRS (SMH) provides, perhaps, a clue (Figure 2). SMH has developed clear negative divergences in both the moving average convergence/divergence (MACD) histogram and the stochastic. Recall that negative divergences occur when prices make new highs, but indicators refuse to confirm those new highs with new highs of their own. Negative divergences don't always result in major or sharp corrections. Sometimes, the result of a negative divergence is as mild as a sideways drift in prices. As such, negative divergences in bull markets -- or even just rallies such as the one that began in October -- can often help traders pinpoint the sort of pullbacks they need in order to make low-risk/high-reward entries in otherwise runaway advances in the markets.

David Penn

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

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November Divergences

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