Signs of divergence present a caution for Bulls

Several technical warning signs for the bullish case, which began surfacing last week, have continued to fester in the equity markets. These indicators in the past have identified potential turning points in the market trend.  At a minimum, they raise a flag to encourage bullish equity investors to tread cautiously. Here is a review of the warning signs:

Negative divergence with Advances vs. Declines (A/D), as A/D has been falling while the indices (Nasdaq, NYA and others) have been reaching toward new highs.  See the chart below:

Related to Advance/Decline statistics, the NY Stock Exchange McClellan Oscillator has turned negative and its cumulative reading, the Summation Index, is dangerously close to a bear market reading near 400.

Bullish sentiment readings taken in investor polls have been peaking. In addition, VIX has settled back into complacency territory, while Put/Call remains low, both contrary market indicators and settling at levels that ins the past have preceded market turns. See charts below:

VIX:

Put/Call:

You will also notice on the chart below of Nasdaq, that price reached toward new highs while the Relative Strength Index, or RSI, a momentum indicator, declined (note the lower highs).  This relationship is depicted in the black oval in the chart, yet another sign of negative divergence spelling caution.

The growing caution signs for the bullish case at this juncture of the uptrend causes us to hedge longs, take select profits and establish partial short positions. Capital preservation is key at this stage. Often, such divergences correct themselves with some much-needed "backing and filling" of the indices, such as a period of consolidation or trading-range activity, before resumption of the uptrend.

Robert F. Palmerton Jr., CMT - December 16, 2010