Tomi Gilmore's recent MarketWatch article ("Bearish divergence is warning investors not to buy the dip in the stock market") reminded me how effective divergences can be in identifying market reversals - well before they occur. Bearish divergences occur when an indicator makes lower highs and lower lows, while price is making higher highs and higher lows. In this situation, something has to give, and it is usually price. Conversely, Bullish divergences occur when an indicator makes higher highs and higher lows, while price is making lower highs and lower lows, indicating that prices will soon rebound.
When applied to the S&P 500 index (SPX) weekly data, the Relative Strength Index (RSI) has been making lower lows and lower highs since 2014, while the SPX has been making higher highs and higher lows - until free-falling in late August.
The top panel in Figure 1 below is a weekly chart of the SPX from 2007 through early September 2015. The bottom panel is the weekly, 14-period RSI. The bearish divergence are shown in red and the bullish divergences are shown in green. As you can see from the chart, bearish divergences preceded both the 2007 recession and the ongoing correction that began in August 2015. For recessions, bearish divergences tend to be extended, often beginning 12 months or more before prices break.
Short-term bearish divergences often lead to quick, sharp, pull-backs, as we saw in 2011. Most bullish divergences tend to be short-term, typically lasting less than 12 months. The bullish divergence that occurred in early 2009 almost perfectly coincided with the low price of the SPX during the Great Recession.
Bearish divergences also occurred before the 2000, 1990, 1980, and 1973 recessions (not shown). A bearish RSI divergence even occurred several weeks before the 1987 crash (not shown). Bullish RSI divergences correctly signaled the end of the 1980, 2000, and 2007 recessions. RSI divergences can be early, but they are not often wrong.
Given the extended bearish RSI divergence from 2014 to August 2015, it could be a rough ride ahead.
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