Technical Thursdays: Homebuilders – Building a Base for a Dead Cat Bounce

The Divergences principle is an anchor of technical analysis and one of its most reliable tools. The logic is simple: price alone tells half the story and is an incomplete measure of a given trend. Price must be confirmed by other relevant indicators that must confirm the given trend otherwise a trend change is likely to occur. When price is not confirmed by other indices, a divergence has occurred and a potential trend change becomes the most likely next move.

Applying the Divergences principle with price, Momentum, and MACD, is an excellent short-term timing tool. If price is not confirmed by Mo and MACD, the odds of a trend change rise substantially. Such is the case with, of all things, Homebuilders!

As the chart above shows, XHB fits the Divergences principles quite well. Price (new lows) is currently not being matched by a confirming low in either Momentum or MACD. What would make this trade even more compelling is if XHB made a new low over the next few days and Mo and MACD improved further. Unless that new low were a plunge to say 20, the Divergence signal would be even stronger.

Investment Strategy Implications

Nothing’s perfect but when the news is both old (on the verge of getting stale) and bad, an investor should begin assuming that the market value reflects most of the current bad news. To be clear, this call is little more than a trade. But placing a modest bet on a beaten down sector is what a contrarian investor (that’s me) is supposed to do.

P.S. The wide gap between price and its 200-day moving average also argues for a bounce.

Note: At publication time, neither Vinny Catalano nor clients managed by Blue Marble Research had a position in XHB.
**Follow up note: Position removed. See September 13 blog entry.

To view a larger version of the chart, simply click on the image.