Many traders and investors have been looking for an explanation of why stocks have been so choppy and indecisive in recent weeks. While one could easily point to a raft of geopolitical factors driving the markets, which may indeed have a bearing on the market environment, we once again find technical analysis provides us with a suitable explanation.
Our swing trading strategy is relatively simple to understand and follow because it is primarily based on price, volume, and trend, rather than a plethora of additional technical indicators. Nevertheless, we continually monitor lesser-discussed indicators in the background because they sometimes provide price confirmation. In recent weeks, one of very interesting thing we have seen is the bearish divergence between the prices of the main stock market indexes versus their corresponding relative strength (RS) lines.
In healthy, uptrending markets, the RS line will typically be trending higher, right alongside of the price of the index. In the healthiest of markets, the RS line will show bullish divergence by breaking out to new highs ahead of the actual major indices. But lately, we have seen the opposite. Although several of the broad-based ETFs and indexes have been trending higher in recent weeks, their RS lines have clearly been showing bearish divergence by trending lower.
On the first chart below, notice that both the Tracey Needham and S&P 500 Index ($SPX) have been trending higher (forming "higher highs" and "higher lows") since late May. However, the RS line has been trending lower (forming "lower highs" and "lower lows") during the same period:
On the next chart, it's a similar situation with the Russell 2000 Small-Cap Index (IWM), which has also been (barely) trending higher, while the RS line has been trending lower. However, bearish divergence is even more notable in this case because the RS line actually broke down to a new low (the black horizontal line), even as IWM has traded sideways to slightly higher:
Below, the S&P MidCap 400 SPDR (MDY) and its RS line is a pretty similar situation to the preceding IWM chart:
What conclusion can be drawn by assessing the three charts above? Primarily, it's apparent that large-cap stocks have been showing more relative strength than small and mid-caps. This is notable because strong, growing markets are frequently led by small and mid-cap stocks, rather than the more established large-caps. Therefore, this is probably not the type of price action bulls want to see.
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