The S&P 500 index makes a new high. Numerous divergences exist. The market continues higher, rendering those divergences meaningless. Eventually, there is a short-lived correction. The S&P 500 retests its prior high on a bounce. There are more cross-market and internal divergences. The market continues higher, rendering those divergences meaningless.
Rinse, repeat.
That’s been the story of 2013 for U.S. stocks. So I’m more than a bit wary to present more divergences as the S&P 500 retests its early August highs. Yet, my wariness does not change the fact that more and more divergences exist. I’ll defer to the words of Justin Mamis in The Nature of Risk, one of my favorite trading books:
“You may not know this is a top. What you do know is that right now there is nothing of consequence to buy. You may perceive that the averages are still going up while certain statistics (easily obtained in the newspapers) – breadth, new highs – have begun not to. Or that in an undefinable (that is nonstatiscal) sense, investor sentiment from comments on TV or in the papers has become comfortable at the same time those failures have begun to surface. Not only is there no precise timing to the potential trouble, but it may even be short-lived, it may be speaking of a simple correction before the move is resumed in better fashion. It may be August-September of 1987.
What has to be understood is that the market, and what we know about its hidden life as conveyed by its language, is not precise, not perfect. The same, of course, can be said about our real, daily life. The absolutes are what we never know. The stock market can teach us that it is only when we accept the ambiguities that we can use language to clarify and thus reduce risk. Yes, this; yes, that. On the one hand, maybe, perhaps, possibly, probably. The coin toss; the odds. Those are the ambiguities you are about to question. What you may not know precisely turns out to be practical. “
While I wish that I had been much more bullish throughout 2013, I cannot ignore what I perceive to be an environment heavily skewed towards risk rather than reward. The alarm bells are ringing even more loudly after yesterday’s move.
For example, high yield credit is making another lower high. This chart closely resembles the S&P 500, but the divergence since the high in May is clear (note: this is a pure credit index, so it is not affected by interest rates):
Similarly, investment grade credit default swaps are making a higher low, another indication of reduced risk appetite in credit markets since May:
Meanwhile, stock market internals are not as strong either.
Here is New Highs on the NYSE over the past year:
This might just be another instance where the market continues higher. Divergences be damned! It’s still a game of probabilities, however. The probabilities are in favor of lower prices in my view, even if the coin’s fallen on heads on all of the key flips so far in 2013.
From riskreversal.com