Non-Divergences Are Better Than Divergences – By Tom McClellan


Chartists love to go looking for divergences of all types, because they can tell us ahead of time that a reversal for prices is coming.  That can be fun information to get.

But divergences are problematic by nature.  They can last for varying amounts of time before they finally “matter”.  And sometimes they can get rehabilitated, with the divergent lower high being eclipsed by subsequent action.  So just because you or I see a divergence in an indicator, that is no guarantee that it has to matter, nor that it has to “work” right at the moment when we see it.

This week’s chart is a great one for showing how divergences can matter.  The indicator in the bottom of the chart measures the number of component stocks in the Nasdaq 100 which are above their own 100-day moving averages.  When I first constructed the database to generate this indicator, I used 200 trading days as the lookback, thinking that it should be the best time period.  It was okay, but after some tinkering I found that 100 days made for a better indicator. 

This indicator gives great divergences at price tops that matter.  So for that attribute, it is a wonderful indicator.  The duration of the divergences can vary, which is frustrating, but they all end up being proven to be “right” eventually.  An indicator which is right eventually is not necessarily what you want to follow for trading signals. 

Because divergences pretty reliably appear in this indicator at important tops, it becomes very useful to observe when there is NOT a divergence.  The absence of a divergence at an overbought reading tells you that the market is likely to NOT be at an important top, and that is the really useful information.  Trending moves are where the big money is made, as opposed to timing the reversals.  But how can one know that one is in a trending move?  That is a really hard question, and the charts often do not give good answers to that question. 

In this case, though, the absence of a divergent top at an overbought condition for this indicator is a pretty reliable sign that there is an intact uptrend, and it is still underway.  That is better information than what you get from a divergence, which has a message about maybe being at a reversal at some point.  The lack of a divergence can tell you that it is okay to hang on and ride the trend for a while longer.  What a wonderful message to get. 

It is also worth noting that this indicator works differently at bottoms, where divergences generally do not appear.  Up and down in the stock market are not the same.

Tom McClellan
Editor, The McClellan Market Report

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About the author

Sherman and Marian's son Tom McClellan has done extensive analytical spreadsheet development for the stock and commodities markets, including the synthesizing of the four-year Presidential Cycle Pattern. He has fine tuned the rules for interrelationships between financial markets to provide leading indications for important market and economic data. Tom is a graduate of the U.S. Military Academy at West Point where he studied aerospace engineering, and he served as an Army helicopter pilot for 11 years. He began his own study of market technical analysis while still in the Army, and discovered ways to expand the use of his parents' indicators to forecast future market turning points. Tom views the movements of prices in the financial market through the eyes of an engineer, which allows him to focus on what the data really say rather than interpreting events according to the same "conventional wisdom" used by other analysts. In 1993, he left the Army to join his father in pursuing a new career doing this type of analysis. Tom and Sherman spent the next 2 years refining their analysis techniques and laying groundwork. In April 1995 they launched their newsletter, The McClellan Market Report, an 8 page report covering the stock, bond, and gold markets, which is published twice a month. They utilize the unique indicators they have developed to present their view of the market's structure as well as their forecasts for future trend direction and the timing of turning points. A Daily Edition was added in February 1998 to give subscribers daily updates on their indicators and also provide market position indications for stocks, bonds and gold. Their subscribers range from individual investors to professional fund managers. Tom serves as editor of both publications, and runs the newsletter business from its location in Lakewood, WA.