Internal Divergences Emerge. Market Pullback Probable.

As noted in yesterday’s Bloomberg radio segment (see below), internal divergences are beginning to emerge for the first time since early August. The accompanying 3 charts* representing 3 key indices (US, EAFE, and emerging markets) illustrate identical action seen in virtually all indices with price moving up while the key near term internal indicators Momentum declining (a clear divergence) and MACD poised to rollover. Moreover, today’s bounce has lifted the short-term indicator (Slow Stochastic) back into overbought territory.

The net effect of the early August internal divergence was a negative 8% for the S&P 500. With so much enthusiasm behind the current market rally (see yesterday’s blog posting illustrating the record low cash levels of mutual funds and the valuation math supporting the current market, as examples), stocks are now in a much higher risk zone than is generally appreciated.

The saving technical analysis grace is the absence of any external (index to index) divergences. That said, a pullback now followed by a further run to higher highs (courtesy earnings season) may produce the external divergence condition necessary to signal an end to this rally followed by a far more meaningful decline. If no external divergences occur in an ensuing rally, however, then the bulls will rule the roost for a while longer.

*click images to enlarge