Emergence of Divergences

JC Parets
June 21, 2021

The process of analysis is such that there are times when trends emerge and times when things are simply messy. Over the past week, with the halt in the trend of the major indices, something emerged on the charts. This something demanded attention.

Negative divergences appear when momentum does not follow the price movement. When there is a disparity between the price move and the indicator, it is a sign of caution. Not to say that a contrary position can be assumed immediately, but the sentiment certainly turns cautious!

So what is it that's hinting at being cautious in this market?

Let's take a look!

The market indices together are saying that the current trend isn't as strong as it seems. Why do we say so?

Here we have our stock universe Nifty 500. This past week's close brought along with it a negative divergence on the chart. As can be seen below, despite the price making a higher high, the indicator went on to mark a lower high. When this happens, we get an insight into the inherent strength of the market. Or in this case, weakness.

Does this mean we can go ahead and start building short positions in the index constituents? Not so fast. This is simply the first sign of caution. Unless individual stocks confirm the weakness, there is no need to jump the gun. What can be considered is observing if the stocks are halting crucial levels that would be logical levels to pause. In those cases, one could consider booking profits and holding on to some cash in order to be prepared when more favourable setups present themselves.

Click on chart to enlarge view.

 

What does Nifty 50 say then? Pretty much the same thing. Negative divergence here as well. So what is our signal?

Do these highs hold their ground? IF they do, then the trend remains in place. But if the price moves below the previous swing high of 15,430, then we're in trouble!

You'll notice that the same story is playing out in other market indices as well such as Nifty Next 50, Nifty 100 etc.

But Mid-caps have been on a rampage! We've seen a 12-month streak of the index closing higher, surely that must be strong? Well, if Shakira were a technical analyst, she'd sing "Charts don't lie".

Like it or not, we've got negative divergence here as well. While the divergence isn't as pronounced as it is on other indices, it is still present. And that is something that shouldn't be ignored. What is also interesting to see is that this pause is coming close to its overhead resistance of 28,650. If there was a level that the index would halt at, this would be a perfectly logical place!

What about the stars of the current market? The Small-caps. Is there something there?

Yes, there is. As the index makes up its mind with regards to direction, the indicator has made up its mind with regards to divergence. A minor one at that.

The other divergence that we're tracking is on the relative strength chart of Small-caps to large-caps. While our favorite risk-on indicator has been making higher highs, the indicator has been making lower highs - consistently. Certainly not what you'd like to see if you're expecting a continuation of the underlying trend.

These are some of the divergences that act as a concern in the current market setup.

As a market participant, what does this mean for you? It means that one needs to be careful and alert. If targets are being met, certain profits can be booked. If stocks are halting at resistances for too long, then position sizes can be reduced.

All this, in conjunction with what your specific stocks are doing with respect to the current trend. There will always be stocks that will outperform others. And others that will underperform. Identify the names that appear on both lists and act accordingly.

Thanks for reading and please let us know if you have any questions.

Allstarcharts Team

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