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Stock Market Divergences
by David Stanowski
31 July 2007


Stock market indexes select a group of stocks to represent an entire sector of the market.

The Dow Jones Industrial Average (DJIA) is composed of only 30 stocks, of the largest industrial companies, but it represents the entire "blue chip" manufacturing sector.

The S&P 500 Index uses 500 stocks, of the largest established companies, from every sector of the economy.

The NASDAQ Composite Index is made up of about 4,000 stocks, of primarily junior-grade companies, that have a lot of growth potential, but are often not as old, or financially sound, as "blue chip" companies.

Much of the time, these three major stock market indexes move in sync with each other, which makes their message clear. This was the case during much of the bull market of the 1990's. For example, if the DJIA makes a new high, and the S&P 500, and NASDAQ, also make new highs, we can be fairly certain that this new high is important, and will lead to further gains.

However, when any of indexes do not confirm the action of the others, the move is more suspect. This lack of confirmation is called divergence. Normally, a divergence is eventually settled by all three averages converging, again, at a later date.

The charts of these indexes, from 1992 to the present time, are shown below. The DJIA made a high of 11,908, in January 2000, it pushed to a new high in October 2006, and it has been as high as 14,121, this month.

The S&P 500 made a high of 1,552, in March 2000, and it just barely made a new high of 1,555 this month, helping to confirm the validity of the new high in the DJIA.

However, the NASDAQ made a high of 5,132, in March 2000, and currently sits at 2,562; no where near a level where it can make a new high, and confirm that the other new highs, will lead to further gains. This major divergence, between the DJIA and S&P 500, versus the NASDAQ, clearly shows that the rally since the 2002 bottom has been narrowly focused in the blue chip sector, and has barely been confirmed by the broader S&P. It is not likely to be confirmed by the growth companies, on the NASDAQ.

This divergence has to be settled in one of two ways. Either the NASDAQ will rally more than 2,500 points, make a new high, and confirm the legitimacy of the new highs, in the other two; or the opposite will happen. Since the DJIA and S&P 500 are both overpriced, by many measures of value, the odds favor that they will fall dramatically to converge with the NASDAQ, on the downside.

DJIA Monthly

S&P 500 Monthly

NASDAQ Monthly


Intra-Index Divergences

Moving beyond these classic rules of inter-index convergence and divergence, we can also look at intra-index convergence and divergence, by recognizing that each index can be used as a barometer in two other ways.

Since each index is made up of the stocks of major U.S. companies, a rising index also, usually, indicates that economic and business conditions are generally positive
; and visa versa. 

In addition, investors must usually be optimistic about the
political and social outlook for the  country, as well as for the economy, to keep buying stocks. Therefore, a rising index usually indicates that there is a generally positive mood, or sentiment, about the direction of the country; and visa versa.

Since the President is the figurehead for the country, he usually gets most of the credit, or the blame, for the direction of the country; whether he deserves it or not. Therefore, the President's approval rating is a good proxy for national sentiment.


Let's examine the action of the S&P 500, from 1992 to the present time, for signs of intra-index divergences:


1992-2000

S&P 500 Monthly

The S&P 500 rose from 400 to 1552, as the official GDP grew at a rate of about 2% to 4% per year, so this index was accurately indicating that the economy was healthy.

GDP

During this period, the country was at peace, there was historical tolerance between most religions, as they apologized to each other for past infractions, and President Clinton enjoyed relatively good approval ratings.

The positive sentiment of this period can best be understood by realizing that the country was caught up in a mania over the easy money that seemed to be available by investing in the stock market. This euphoria was enough to keep President Clinton from being convicted, even after he was impeached. Most people just didn't feel like pushing it that far. If the mood had not been this positive, he would have been removed from office.
The rising S&P accurately reflected a positive national sentiment.


2000-2002

S&P 500 Monthly

The S&P dropped from 1552 to 768, as the official GDP rate fell from 4% to 0% per year, 
so this index was accurately indicating that the economy was weakening.

GDP  

The national mood turned ugly in the aftermath of the 2000 election, our time of peace was ended with the 11 September 2001 attacks, and these attacks ushered in an open undeclared war between Islam, and most other religions. President Bush's approval ratings jumped after the attack, but this only lasted for a month or two. The falling S&P accurately reflected a negative national sentiment.

Bush Approval Ratings


2002-2007

S&P 500 Monthly
 
The S&P 500 rose from 768 to 1555, as the official GDP grew to a rate of 4% per year, in 2004, but since then, GDP has continued to weaken, even as the S&P 500 hit a new high. Towards the end of this period, the economy has been rocked by the fallout from the housing bubble, and the sub-prime mortgage crisis, so this index was not in sync with the economy!

GDP

The War on Terrorism grinds on, and becomes more and more unpopular, conflicts between groups, both religious and ethnic, are increasing, the President's approval rating continues to hit new lows, while the approval rating of Congress has hit an all-time low. The divergence between the President's approval ratings, and the action of the stock market is the widest, and longest in history!

Bush Approval Ratings


During the first two periods, in question, the action of the S&P 500 Index was in sync with the state of the economy, and the sentiment in the country. From, 2004 to 2007, this has not been the case! There is a MAJOR INTERNAL DIVERGENCE!

It is very perplexing to try to explain why the S&P 500 has risen to a new high, even as the economy is weakening, and national sentiment gets more negative, until the effects of inflation are considered!



Inflation

There are many possible ways to remove the inflationary effects from this index. It could be adjusted using the Pre-Clinton CPI, the Post-Clinton CPI, the CRB Commodity Index, one dominant commodity (such as oil), a basket of foreign currencies, a hard currency (such as the Swiss Franc), or gold. All of these choices have their pros and cons, but I will use the only real store of value that has stood the test of time; gold!

When you divide the S&P 500 by the price of gold, each month, it becomes clear that the move to a new high, measured in dollars, has actually been a fiction! The "Bull Market" of 2002-2007 has been the product of a currency, possessed of less and less purchasing power, that required more and more dollars to buy the same stocks! Classic inflation!

As usual, this divergence between stock prices, the economy, and national sentiment will end as these components converge in one direction. The weight of the evidence says that the index has a long way to fall, in dollar terms, to be in sync with the weakening economy, and the negative national mood. 

S&P 500 Monthly

Deflated S&P 500 Monthly
Note how the Deflated S&P 500 has not only
NOT made a new high, it has made a new low,
below the 2002 low!



Graphs of the DJIA and NASDAQ, with the effects of inflation removed, show the same kind of pattern as the one in the S&P 500.

DJIA Monthly

Deflated DJIA Monthly
Note how the Deflated DJIA has not only
NOT made a new high, it has made a new low,
below the 2002 low!



NASDAQ Monthly

Deflated NASDAQ Monthly
Note how the Deflated NASDAQ has not only
NOT made a new high, it has been flat
to lower for the last 5 years!


Conclusion

The inter-index divergence between the DJIA, the S&P 500, and the NASDAQ; the intra-index divergence between what the rally in these indexes says about stock prices, versus the deteriorating economy, and the negative political and social climate; and the divergence between these indexes and their inflation-adjusted counterparts, all carry the same message. The stock market has little room on the upside, and a lot of potential to move to the downside!

The charts of the inflation-adjusted indexes paint a very clear picture of what has happened, in this country, over the past 4-5 years. Roaring inflation has pushed up the stock and real estate markets, which has created a boom for those who work in these industries, and for those who earn most of their income from these investments. The good fortune of this "financial class" has been the subject of much media attention, so that it often sounds like everyone has been doing very well. Unfortunately, most people have been fighting rising prices, and falling real wages, caused by this inflation; without the offsetting windfalls from these investments!

While it is true that many Americans have some stock ownership, most do not earn a significant portion of their income from the stock market, so the rally since 2002 has had little effect on their current standard of living. However, some members of the middle class did "withdraw" the equity in their real estate, which allowed them to join the party that the financial class was enjoying; but, unlike them, they still have to pay back those loans! 

This wide divergence between most people, who rely on their wages, for their standard of living, versus the financial class, and those binging on equity withdrawals, has also just about run its course. The fortunes of the financial class, and those inflating their lifestyle with borrowed money are already starting to converge with the rest of the country.


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