Cintolo Spots a Rare Divergence between Indexes and Leading Stocks

August 25, 2010

Cabot Editor Urges Caution and Patience

In today's Cabot Market Letter, editor Michael Cintolo wrote about a market divergence that he hasn't seen before:

"Divergences in the stock market are great tools that often presage some change, either in the direction for the market as a whole, or a change in relative strength among a group of stocks. Indeed, the classic example of a divergence is when the major indexes advance while the vast majority of stocks lag; this is an early sign of a developing market top, which is what our Two-Second Indicator is designed to spot.

"Today, however, we’re witnessing a highly unusual type of divergence … one that we can’t remember seeing before. On one hand, there's the sloppy, downtrending action of the major indexes and a variety of key sectors like the financials (such as the Financials Select SPDR, symbol XLF) and semiconductors (depicted by the Philadelphia Semiconductor Index). The XLF has been unable to get above the 15 level for months, and is now probing its yearly lows. Chip stocks actually did hit a new low two weeks ago, and have been unable to get off their knees.  We must also mention that, since May 21—three full months ago—the Nasdaq Composite has had just one day of gains on above-average volume. Not good!

"So a maximum cash position is advised, correct? Not so fast. As you know, many leadership-quality stocks have been holding up very well, and many have actually been advancing during the past couple of months. We won’t present the whole list here, but suffice it to say that many stocks in the Cabot Market Letter Model Portfolio and on our Watch List have notched worthwhile gains of late. And if you’ve been nimble enough to buy on pullbacks (and possibly sell some during rallies), those gains have been great!

"The question is, what do you believe? The major indexes and the majority of stocks, or the leading stocks that possess the best sales and earnings growth? Of the two, you should give more weight to the overall market. The reason is simple: A poor market has the ability to drag down all stocks with it, and we’ve seen that a few times in recent months—the major indexes sell off for a few days, and even the best-looking leaders get whacked on the head … and a few even break down completely.  Said another way, if the indexes are trending lower—as they are today—your margin for error when buying stocks is microscopic.

"But, as we wrote above, that doesn’t mean you have to be all in cash. We still think it’s best to go with the evidence in front of you—continue to hold your strong, resilient stocks, and do a little new buying during periods of weakness. But also be sure to hold plenty of cash, work on your Watch List and practice plenty of patience as you await the time when the bulls arrive in force."

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