Sign Of Market Thinning: Strong, Weak Stocks Diverging

Every weekend I review the charts of the 50 most active stocks on Twitter then place them into categories. This past weekend I noticed that the number of stocks in a confirmed downtrend is growing. In addition, the number of stocks in a confirmed up trend is growing too. The number of stocks that are unclear, showing a divergence, or indicating that a counter trend move is falling.

This is somewhat disconcerting for the longer term because it suggests that market participants are piling on to the strong stocks and ignoring the weak stocks. This type of divergence is often one of the first signs of a thinning market. The value players have stopped trying to pick up stocks in down trends while the momentum players are buying anything in an up trend.

Our concern is that we may be in the early stages of a blow off top. We want to see this situation resolve with more interest in the weak stocks and also some divergences in sentiment for the strong stocks. Negative divergences would indicate that traders aren’t getting too giddy.

Another chart we watch to see if the market is getting too divided is the relationship between the ProShares Short S&P 500 Index (SH), an actively managed short ETF, and the Ranger Equity Bear ETF (HDGE), and the volatility index iPath S&P 500 VIX Mid Term Futures ETN (VXZ). When HDGE starts trending upward it signals that traders are pressing their shorts and that weak stocks aren’t likely to recover soon.

Adding to the longer term warning is that mid term volatility is rising which signals investors are protecting their portfolios for an event in the future. When this occurs, they often start slowly raising cash as well. That means more selling of the weak stocks and profit taking from overextended stocks.

At the moment this isn’t a huge concern, but it is something that tells us we need to start focusing on market breadth as an important indicator going forward. These are the first subtle signals that longer term sentiment is changing. If the market makes it back to new highs and market breadth diverges, it will be our next signal that the market is thinning.