I heard some talk this week of signs that bears were now surrendering. There has been a huge flood of money into equity funds (http://on.ft.com/UxYUfB) lately, something that also happened in September 2007, just weeks before the catastrophic credit-crunch induced collapse got under way. Punters are clearly taking their lead from pundits, among whom 54.7 per cent are bullish and just 21.1 per cent bearish as of this week. A scarcity of bears is another common feature of highs.
Many bulls, few bears
I don't buy the comparisons with late 2007. The key differences between then and now are cheap and plentiful liquidity and much more competitive valuations, especially outside of the US. However, the risks of a temporary retreat in Wall Street and in the UK have grown. The sharp reversal on Monday 4 February and the subsequent rebound was the sort of volatility that anecdotally often occurs around the end of rallies.
Short, sharp dip in FTSE
In last week's column, I discussed how very overbought the FTSE 100's daily momentum readings had become. (You can watch a brief video of my conclusions here: http://bit.ly/XNnyFs) I showed how the typical pattern was for the index to keep rising while its momentum reading tailed off. This condition - known as 'negative divergence' or 'bearish non-confirmation' - is now in evidence for the FTSE and the S&P 500.
S&P's divergence
For the S&P, negative divergence has been a harbinger of most of the significant highs since March 2009. In that time, there have been seven highs leading to corrections, by which I mean a pull-back of at least 5 per cent, based on closing prices. Of these, five - and arguably six - saw negative divergence at the peak. The only clear exception was the peak of September 2012, where the index and its daily relative strength index (RSI) climaxed simultaneously.
While negative divergence means a correction is now closer than when the markets were simply overbought, it is not a precise timing device. In a strong uptrend, it can persist for a quite a while. Take last spring's top, for example. The S&P's daily RSI reading peaked at 75.3 per cent on 9 February, when the index was trading at 1352. The correction began only on 3 April, after the S&P had gone up to 1422. Had one bailed out - or worse still, gone short - based on negative divergence, the profits foregone or losses would have been substantial.
Bollinger not frothing over
My solution to this would be not to rely on negative divergence alone. One possibility is to combine it with another indicator, such as Bollinger bands. The Bollinger bands are mathematically constructed lines either side of a moving average, typically one of 20 periods. Plotting these lines at three standard deviations from the average, I notice that the S&P has generally come up against the upper line shortly before peaking. That's not happened just lately.
Ultimately, though, only a reasonably determined fall is going to make me think that a correction may be under way. At the very least, I'd like to see the S&P and other indices close firmly below their 20-day moving averages. Until then, I shall keep faith with the uptrend, with fresh bull-market highs in my sights.
