The Divergence to Keep on Your Radar

Global Macro Monitor produces informed opinion about markets and the global economy. This was originally published on January 21, 2011.


Just looking at the the Dow, which was up 0.72 percent,  it wasn’t a bad week.   Look again!

Mr. Market inflicted some heavy pain this shortened trading week and we’re feeling some of it.  We’ll discuss  in more detail what took place during the past few days in our upcoming Week in Review post.

Check out these charts, which illustrate  the huge divergence this week between the small caps and the Dow.   The Russell 2000 began its 4.26 percent swan dive at the open on Wednesday to close at its lows on Friday.  Meanwhile,  the Dow Jones Industrial Average closed up 0.72 percent for the week led by big gains in GE, IBM, Hewlett Packard, and Exxon.

We suspect this just may be profit taking from the Russell’s huge run-up in 2010 as many of the stocks that were up big over the past year also got whacked during the week.    The size of the divergence does raise a red flag, however.

Only twice in the past seven years has the Dow and Russell experienced close to a 5.0 percent performance divergence in just four trading days and those occurred in 4Q 2008, during the height of financial collapse.   The Russell 2000 is a favorite hedging and shorting vehicle for the fast money crowd and the divergence may be a false signal as the shorts rush to cover,  but it’s worth keeping on your radar.

The last chart also shows that the two bull markets of the new millennium,  reflected in the S&P500, have been confirmed by the Russell 2000 outperforming the Dow.   The converse is true during bear markets.    The S&P500 can continue to rally even as the Russell:Dow ratio turns down,  but it’s clear the ratio is a  leading indicator of major trend reversals and deeper corrections.

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