In a week full of economic reports and an FOMC meeting, it was the stock of a company that operates a chain of game stores that got the market’s attention. The company, of course, was Gamestop GME (GME), founded in 1994 as Babbage’s in Dallas, Texas. Most investors and traders are well aware last week’s action as the stock was up 400% for the week and 1625% for the month, despite a 44% drop on Thursday after hitting its all-time highs earlier in the day.
The short squeeze intensified when it became apparent that 130% of GME’s available shares were sold short, and that hedge fund Melvin Capital needed an infusion of more than $2 billion to remain solvent after GME’s price skyrocketed, forcing them to close out their short positions. This story is unlikely to go away, as reports suggest a loss of $5 billion by short sellers on GME so far this year.
There were a number of analysts that, early in the week, did not see this volatile action in GME as a problem for the overall market. As I pointed out last weekend, a bearish or negative divergence had been formed in the daily Nasdaq 100 A/D line for the first time in over a year. This was in addition to other signs of elevated market risk and investor complacency.
Given those warning signs, it was not surprising that it was a rough week for the markets, as every major market average closed lower. There were consistent losses of 3.3% in the Dow Jones Industrial Average, the Nasdaq 100 Index NDAQ and the S&P 500. The Dow Jones Transportation Average ($TRAN) was hit the hardest, down 6%, followed by a 4.4% decline in the iShares Russell 2000, which was the most extended of these averages at the start of the week
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The weekly chart of the iShares Transportation Average (IYT) shows that last week’s close (point d) was below the Quarterly Pivot (dark blue) for the first time since May 29, 2020 (point b). The close was also below the uptrend from the March 2020 lows (line c) and the weekly starc- band. There is next good support at $204.17 (line a), which is 4.1% below Friday’s close. The MACD-Histogram also turned negative last week after forming lower highs, which was a negative, or bearish, divergence from the new price highs.
Divergence analysis is an important concept in technical analysis. Simply put, if the market is going one way, but indicators are going another, that may indicate an upcoming trend change. The divergences observed on the weekly charts are the most significant, and they can be observed at both market highs and market lows. Often divergences from the daily data are only warning of a pullback within the major trend, while weekly divergences often correlate with a longer-lasting change in trend.
To demonstrate the importance of spotting divergences, I’d like to examine the well-documented $1 billion trade by George Soros in the British Pound that occurred in September 1992. The weekly chart of the British Pound futures shows that the 7-week relative strength index (RSI) peaked the week of July 17, 1992 when the Pound closed at 1.8900. Seven weeks later, on September 4, the BP closed at 1.9942 as it made significant new highs (line a) while the RSI was making lower highs (line b).
The Pound was sharply lower the next week and on September 16, also known as Black Wednesday, “the British government was forced to withdraw the pound sterling from the European Exchange Rate Mechanism (ERM)”. By February 1993, the Pound had made a low of 1.4110 (line c). The lower lows in price were accompanied by slightly higher lows in the RSI (line d), forming a positive, or bullish, divergence.
The failed attempts by the British government to prop up the Pound by raising rates pushed the economy into a recession. The Conservative party was forced out of power for several years, as the country tried to recover from a collapse in the housing market and a deep recession. George Soros has often received some of the blame, as his short selling in the Pound, which was reported to have made him $1 billion, made it more difficult for it to rally.
On Monday, the Invesco QQQ Trust (QQQ) QQQ made a new high at $330.32 on Monday (line a) and overcame the starc+ band at $329.66. But by Friday, the QQQ closed below the daily chart support (line b), and reached the daily starc- band. Starc band analysis indicates that when prices are at the starc- band, it is a high-risk time to buy and a low-risk time to sell. By Friday’s close, QQQ was in a low-risk buy area, and a high-risk sell area. This could mean that QQQ is in a position to rally, but there is no sign that a bottom is in place. There is now a band of support in the $310.17 to $302.91 area.
The negative divergence in the daily Nasdaq 100 Advance/Decline line (line c) that was mentioned last week has now been confirmed, as the A/D line has dropped below the prior low (see arrow). This means that the A/D line could eventually decline to the next good support (line d).
The Spyder Trust (SPY) SPY also dropped below its daily starc- band on Friday, breaking below the support (line a) with a the low of $368.27. The January low is $364.82, with the 38.2% Fibonacci support for the rally since September 2020 at $360.62. A close below this level would suggest a move to the 50% support at $352.83 which is just above the weekly starc- band (not pictured) at $351.42.
The daily S&P 500 A/D line made a new high on January 20, unlike the Nasdaq 100 A/D line, and so did not form any pronounced negative divergences on Tuesday’s high at $385.85. The support (line c), however, was decisively broken last week, and so, like the Nasdaq 100, the S&P 500 A/D line is in a clear short-term downtrend. There is next support at the A/D line’s October 2020 highs (line b). The number of S&P 500 stocks above their 50-day moving average has declined from 83% on January 20 to 43% in Friday. This is a sign that the market risk is lower. However, this figure often drops to 20% at correction lows, so the correction may not be fully over.
The economic data last week came in better than expected. Both the Consumer Confidence and Consumer Sentiment did not show any large changes, which is an encouraging sign. The Fed’s favored measure of inflation, the Employment Cost Index, came in at 0.7%, above the expected reading of 0.5%. This week the focus will be on Friday’s monthly jobs report, as well as the many companies reporting earnings this week. I wondered earlier this month if earnings would justify the high stock prices, and so far, the markets have responded favorably to earnings reports.
Last week’s data suggest that the correction will carry over into February. A rebound is likely next week before a further decline. I think a deeper decline is needed to reduce the high level of complacency I discussed last week. It should present a good buying opportunity for selected ETFs and stocks.
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