Studying the supply and demand of markets can give you great insight as to whether a market will move higher or lower. Divergence Analysis is a method of evaluating supply and demand information and recognizing market forces that are moving in opposite directions. What does this mean for you? Divergence Analysis can be a great tool for investing – with results of over 90% accuracy when multiple sources or indicators are used in the analysis.
In 2007 through 2008, the inventory of homes available for sale in the US continued to grow while the number of homes sold continued to fall. The two pieces of data were moving in opposite directions, creating a massive divergence between the supply and demand of homes. This divergence indicated that the price would have to move lower as there were more homes for sale than there were buyers. The result was that banks began to fail as individuals couldn’t sell their homes for the price they paid. Using the data for supply and demand could have allowed one to avoid the housing market during this time.
When evaluating the stock market using Divergence Analysis, you will find the advance/decline line to be extremely useful. Between January of 2000 and March of 2001, the advance/decline line was moving increasingly lower, while the Dow Jones Industrial Average did not move below ten thousand. Some particularly strange behavior; stocks were moving lower and the overall market was not. This divergence between the number of stocks moving lower and the average staying high should lead us to say “what is going on here?” and take money out of the market. The Dow Jones ended at 7,197 in September of 2002, which was an astonishing decline of 36% from its peak to its lowest point.
Adding a third indicator to our growing list of Divergence Analysis allows for an even deeper understanding of the market. A good indicator can be found by looking at the relationship between Dow Jones Industrial Average and the Dow Jones Transportation Average. Dow Theory suggests that if business is good, then the transportation average should be doing well too. This concept makes sense as most products and services require the use of transportation to their locations for distribution or sale. However, there are times when these two indicators diverge and create opportunities for the astute investor. In November of 2016, the Transportation Index made a new high while the Dow Jones Industrial was falling. This divergence has led to a positive market that is up approximately 26%.
Using Divergence Analysis can improve your investment performance and make you feel more comfortable with markets and their values. Adding the above three indicators together would be a great start to watching the markets and reviewing for yourself what the economy is really saying. At Fogel Capital Management, Inc. we consider this type of information daily and implement these investing theories for our clients. If you would like to discuss this article further, feel free to call me at 772-266-3431 or email Michael@FogelCapital.com