Divergences Build as Indices Reach New Highs

Although traders and investors are taught to treat the "trend" as their "friend," we cannot always wholeheartedly trust that friendship as the trend grows older.

As the markets tangle with new highs, several divergences in market index activity have begun to surface, and investors are cautioned to heed their potential warnings.  This is not an indication to give up on the bull trend, but a subtle suggestion to protect capital and to avoid chasing the rally.

Once such divergence has been the performance of financial stocks as measured by the comparison of XLF to the S&P500.  As the S&P500 has reached a new high, the XLF:SPX ratio has lagged in a consolidating pattern.   Financials have been considered to be an important part in confirming a trend.  Their recent divergence is cause for second-guessing the strength of the rally.

Another divergence that has surfaced is the outperformance of value stocks vs. growth stocks.  In "risk-on" environments supporting stock market rallies, growth tends to outperform value.  Similar to the XLF:SPX relationship, growth vs.value has also begun to churn downward:

Finally, strength in small cap stocks (like growth stocks) are considered indicators of the "risk-on" trade and supportive of market rallies.  Small Caps however peaked most recently in March (lifted from their trough in October) and have corrected rather sharply in the last 3 weeks.  As the chart below also demonstrates, small caps tend to lag the broader market by 18-24 months peak-to-peak.  A similar pattern, if it plays out as it has historically, would suggest rough going for the major indices potentially starting in the next 30-60 day timeframe:

These divergences (and others that have begun to emerge, such as declining peaks in relative strength and the failure of transportation stocks to yet reach a peak as the DOW has), should be considered as a warning for traders and investors to avoid randomly throwing capital at the stock market. This would be an appropriate time to set stops, take a few profits and prepare a buy list for a meaningful pullback.

- Baseline Analytics