Divergence: Leaders Pulling Away

• Posted by DynamicHedge
• on April 5th, 2011

I track a lot of market statistics.  One of them is the average true range of correlated pairs across all sectors.  Most of the time the aggregate average intraday move is 55%.  Today we watched a 2-standard deviation move in average pair divergence — which means that investors of all stripes are pushing leadership stocks and ignoring the peers.  Pairs that usually have reversion to the mean tendencies have been steadily diverging.  Historical correlations and cointegration don’t matter when traders decide to concentrate the momentum into a few names.

So what does this mean?  While the S&P 500 Index is stuck in a rut, biding its time before deciding to make new highs or flush everyone out, the leaders are running away from the herd.

Tech, basic materials, and industrial stocks have been big momentum plays.  Basic materials stands out as oil, steel, and precious metals breakout to new highs.

Materials ETF XLB versus the S&P 500 ETF SPY for the last month.  Click for a larger view.

I’m starting to see a pronounced differentiation in leadership stocks versus their industry peers as evidenced by the persistent intraday divergence.  Buyers are sticking with the momentum names like sector leaders IBM and BTU.

IBM and BTU are both leaders and their closest counterparts have massively underperformed.

The VIX is in the teens and momentum stocks are lifting off.  Playing the game of “buy the laggard” and hope it catches up is just not working.  And don’t even think about getting short these heavy momentum stocks.  Overall, conditions are really lousy for fading price anomalies or to playing reversion to the mean.

The time to be very fearful is when all stocks start rising with no regard to pedigree.  When it gets too easy, the rally is over and it’s time to get back to a two-way market.

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