Divergences between the financials and the market as a whole often provide a leading indication as to what may lie ahead in the market. The following charts illustrate what has happened in the past when these divergences have occurred.
On this chart financials (XLF, dashed line) are plotted against S&P 500 (thick line), click to enlarge:
As you can see I was able to find 10 divergences between those two charts.
- 1, 2, 4, 6, 8, 9, 10 are negative divergences followed by a red vertical line at the last peak
- 3, 5, 7 are positive divergences followed by a blue vertical line at the next bottom
- The most powerful negative divergences are 2, 8 and 10. 2 and 8 were followed by quite a sizable decline in stocks, 10 is the current one, yet unfinished
Now let’s get back in time into previous bear market, split in two charts for better visibility:
The only false signal I spotted was in June 2001. Now the second chart:
In this second period I was unable to find any significant divergence, the stocks moved pretty much in a lockstep.
This is not recommendation to buy or sell anything but the invitation for discussion 
10 Comments
Regarding their mutual correlation, and given that FIRE makes up a growing majority of the US economy, you’d expect that they would not remain divergent for very long. Although one or the other may be leading or trailing at any particular time.
Hey Roxy,
Congrats on your new location.
Not sure on your definition of divergences here, but the only divergences on your first chart that I see are labelled 2 and 10.
That is, the SPX made a higher high while the financials made a lower high. I am not sure one asset making a higher high, while the other makes a weaker but still higher high is really a divergence. Nor is one asset making a lower high while the other makes an even lower high a divergence.
Having said that, divergence 2 picked a pretty significant high in the S&P, and perhaps is signalling the end of a bear market rally.
I sure hope so - got some SKF and short index positions entered last week. If not, stop out and live to fight another day.
To add to the above - there is only one bearish divergence on your 2001 chart - right in January, and it preceded a hefty decline.
Looking at bullish divergences, you seem to be using the highs. I think most people would use lows - a bullish divergence would have the S&P making a lower low while the financials made a higher low e.g. August 2007 in the first chart or April 2002. These are areas you identified, but you seem to have used highs not lows.
Anyway, interesting stuff.
And just to continue my shameless hijacking of your blog - you seem to have it right in your third chart between the Feb / Mar 2003 blue lines where you have indeed used the lows.
Ok - enough for one day!
Thanks, I probably need to spend a bit more time and find out the best chart parameters that will allow to spot and plot divergences. So far it was a bit of bubble gum
Follow-up: by my theory today trading action only confirms that the market is very rotten.
After visiting multi-month hights S&P dropped to only 0.09% but financials fell -1.02% and KRE and IAI are down as well. There is a concrete ceiling right above this market
About divergence: I think it’s appropriate to define divergence as a visually obvious fork between one chart and another. It’s not necessary that they are moving in opposite directions as long as the fork is wide
What I’m thinking is that financials could be a good hedge.
Either stocks will go down or financials will catch up. As I’m short I can pick some out of money financial calls as a hedge in case they want to rally. If not the hedge will just expire.
Ceiling is the 200 DMA?
The stocks are down -1.6% but financials tumbled -2.5%. Stocks have a lot of downside ahead to catch-up. They have to catch-up, they always do.
Big article is coming tomorrow
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