Major market divergences can be an alarming sign…
They’re exactly what I’m watching for, right now, to tell me when the end of this bull market is imminent.
When the overall market hits a new high and important sectors like transportation or financials don’t, it’s a bad sign. These major divergences are warning signs that the market is weakening.
That’s not a universal rule, though. Some divergences can be a positive sign. And we recently saw one of those when stocks hit new all-time highs just a few weeks ago.
The S&P 500 Momentum Index recently failed to break out to new highs alongside the S&P 500 Index – creating a divergence. But interestingly, this is actually a good sign for the overall market.
History says it’s one more reason stocks can move higher from here.
Let me explain…
Cheap, hated, and in an uptrend. If you’ve read my work for long, you know that phrase. It’s my investment mantra.
What you might not know is that the uptrend – better known as “momentum” – is the most important part of the equation. I always wait for prices to move higher before investing.
The S&P 500 Momentum Index uses this same idea. It focuses on companies with a high “momentum score.” These are the companies in the S&P 500 that are going up.
Momentum works over the long term. This index has outperformed the overall market over the last 25 years. But that hasn’t been the case in recent months.
That’s what caused the recent divergence… when the S&P 500 hit new highs but the momentum index didn’t. You can see it in the chart below…
This kind of divergence has only happened 4% of the time going back to 1995. But it’s not a reason to fear… It’s actually a positive sign for stocks.
Since 1995, similar divergences have led to a winning trade 86% of the time. And solid outperformance tends to happen after these occurrences, too. Take a look…
The U.S. stock market has been the world’s greatest wealth creator over the last century. And since 1995, it has produced annualized gains of 7% per year. But buying after divergences like the one we saw recently has yielded even better results…
Similar cases have led to 2.1% gains in three months, 4.4% in six months, and 9% over the next year. These are not huge figures. But they are solid outperformance numbers.
More importantly, they don’t tell you the story you might expect… that all divergences are bad. That’s usually true. But major divergences aren’t always a gloomy sign for the market.
Today’s occurrence is a perfect example of that. It says we can still make money from here. And that’s why – despite the recent market weakness – my advice remains the same. Stay long.
Good investing,
Steve
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Source: Daily Wealth