Important Divergences

May 17, 2009 – Occasionally the stock market gives important clues about its future direction. One way a clue can appear is through a divergence

For example, as the Dow Jones Industrials, S&P 500 Index and other major indices slid lower over the past several months to their recent bear market low on March 9th, the number of stocks trading on US markets that have made a new 52-week low has also declined. In other words, even though the stocks in the major averages were making new 52-week lows, they were followed by fewer and fewer individual stocks.

It was a divergence. The broad market (i.e., all stocks traded on US exchanges) was not confirming the new low being made by the major averages. The divergence was signaling that a bear market rally was approaching, and as we now know, a bear market rally is indeed underway. Thus, the divergence was not a precise timing tool stating when the bear market rally would begin, but rather, an early warning indicator that one was approaching.

Here is another important divergence. When the major stock market averages dropped last autumn in the aftermath of the collapse of Lehman Brothers, investor money rushed into US government debt. Yields on 10-year T-notes, for example, declined to 2.03%, a record low. Even though the major market averages continued to drop this year, yields on US government debt instruments have risen. The 10-year T-note for example, presently yields about 2.95%.

The yield on T-notes and the major market averages have diverged. The reason for this divergence is unclear for now.

For example, it may mean that US government debt instruments are no longer seen as the safe haven they once were in the weeks following the Lehman collapse. In contrast, it could mean that investors no longer need a safe haven from the carnage in the stock market. Another possibility is that investors are no longer willing to buy T-notes because of the rising inflationary risks down the road as the Federal Reserve pumps up the money supply. And there may be other possible reasons.

The point is that we may not be certain of the reason that the stock market and T-notes are diverging, but that they are diverging is an observable fact. Consequently, this divergence should not be ignored, and should be taken into consideration in the asset allocation decisions for every portfolio. The trend in T-note yields appears to have turned, which will be confirmed if T-note yields climb above their recent high around 3.07%.

Similarly, here is another important divergence that should not be ignored. As the stock market averages declined this year into their recent 52-week low on March 9th, the XAU Index of mining stocks has been rising, as is clear from the following table.

Since last autumn the XAU Index has been rising even as the major stock market averages were falling. It is a noteworthy divergence, but the important question is, what does it mean?

A divergence such as this one is open to many possible interpretations, but the most likely one to me seems clear. The mining stocks are showing considerable strength independent of the general market by bucking the downtrend in the major averages. Relative strength like this often indicates that the strong group, in this case the mining stocks, is ready to launch a bull market. In short, even though the XAU Index has already shown impressive gains since October, I think there is more to come.

Lastly, divergences are more meaningful when the group showing strong relative strength is also undervalued. I think that the following chart demonstrates that the XAU Index, based on historical evidence, is undervalued at present.

In conclusion, it looks like 2009 will be a good year for the gold and silver mining stocks. Look for improved profits by these companies, which typically is followed by higher multiples. Taken together these two factors mean higher stock prices.