A Big Red Flag Is Pointing to a Stock Correction

The stock markets are sitting near all-time highs, and technology has been the strongest sector this year, but it's lagged recently as financials, healthcare and industrials have shown strength over the last month. But a negative divergence in the Relative Strength Index (RSI) and the Moving Average Convergence Divergence (MACD) vs. Stock Price has been forming, and it deserves close a close look.

This means that while prices have rallied, the momentum and relative strength of the market have made a lower high compared with a previous peak. And when market breadth doesn’t keep up with price, this can indicate that a reversal is imminent.

This negative divergence between the RSI and MACD​ is a sign that market breath is declining, meaning that fewer stocks are participating in the rally. And when a market is being propped up by only a handful of stocks or sectors, if those stocks start to roll over, the market can suffer a sharp correction because there’s nothing left to support it. The SPDR S&P 500 Trust ETF (SPY), which tracks the S&P 500 index, has held between $240 and $242 for over a month. But if this level is breached, the market could be in for a correction, as this would be a major sell signal.

One explanation for this negative divergence is worth mentioning — one that doesn’t necessarily point to a correction. The RSI negative divergence comes on the heels of massive overbuying at the end of February, when it reached an unsustainable level. Stocks are unlikely to rally so hard that the RSI hits 80, as this is extremely overbought, so to expect the recent run-up to match this RSI high is unrealistic.

The reason it is so unlikely to hit 80 is because usually when a stock’s RSI hits 70, a pullback or at least a pause, ensues because this is the level that is widely considered to indicate that a stock is overbought. Then any slight pullback would bring the RSI down to a more reasonable level. Hence, hitting an RSI of 80 is even more unlikely.  

The Bottom Line                        

Nonetheless, a negative divergence is a big red flag and should warrant caution regarding the health of this year’s rally. There are no glaring sell signals in the market yet, but if one arises over the coming weeks it should be taken seriously.