E Yellow Flag Is Up Cautioning MOMO Traders - Dow Divergence In Momentum Cause For Defensive Posture

With major averages a few percentage points from record highs, there is cause to raise a little cash and buy cheap puts against the major averages before premia blow out.  

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Dow Internals

As the Dow Industrials approaches the October '18 peak of 26,951.81, monthly momentum divergence has become a concern. In classical TA, it's important that momentum oscillators confirm price action. However, as the chart illustrates, RSI is substantially lagging as are most other momentum indicators. We take classical TA with a grain of salt because indicators like the RSI are lagging and there is a chance RSI catches up. If you play out this scenario, should RSI break out to confirm a high, it will come at the expense of extremely overbought market conditions, similar to the October '18 peak which was the highest monthly overbought reading in history.  Moreover, since the late 1990s, momentum divergence has proven to be an issue for the Dow.

On the other hand, if the Dow breaks through the 27200 area, it could easily trigger a surge to 29k-30k, at which point I see a reversal as virtually assured, especially if the momentum divergence continues into that move. If the market runs out of steam here and the Dow retraces below the March low of 25,928, it will register a downtick in the monthly RSI which confirms a divergence and validates the signal. In this scenario, downside velocity could rise substantially with a massive spike in volatility. 

OTM puts on the SPY, DIA and XLI offer low-cost insurance against this current rally turning out to be a bull trap. 

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Russell 2000 / DJ Industrial Ratio

The above daily chart shows the Dow on top but what's important is the blue line below which represents a ratio of the Russell 2000/DJ Industrials. Another way to look at this is Small Cap vs. Large Cap. In almost every major Dow top, declining relative strength in small-cap stocks was an early warning indicator. Best case, this type of divergence between small and large cap stocks suggests an erosion of market internals. As internals continue to deteriorate, the foundation which the market stands on starts to crumble. Worst case, the internals are an indication of smart money taking risk-off because of clouds forming over the horizon that "Main Street" has not yet observed. 

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Disclaimer: This report is for informational purposes only and does not constitute individually tailored investment advice. Alpha Insights is not a registered investment advisor.

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