Divergence

In last week's sell off the word “divergence” was mentioned frequently by traders around the internet electronic bulletin boards, maybe the modern day equivalent of the tea-houses and coffee shops that sprung around Threadneedle Street in the 18th century where the then gentry would chatter about investment opportunities.

But what does divergence actually mean? In technical analyst terms, divergence can be either positive or negative, both of which can be signals for a major shift in price. When positive divergence exists, several conditions occur. For example, the asset price makes a new low, simultaneously all the other fundamental indicators point in the other direction. So take a hypothetical example where company X's share price has just crashed through support levels but the fundamentals starts moving in the other direction. Company X's demand for its products or services are increasing, company X's market share is growing, pre tax profits are beginning to rise. This would be an example of a positive divergence in company X's share price and it is a buy signal, according to fundamental analysts.

Negative divergence is the reverse and it occurs when the price of the security makes a new high, but the indicator fails to do the same and instead closes lower than the previous high.

Let's take a look at some background information regarding resistance and support price levels so that this makes more sense to those of us new to the technical jargon.

Resistance is defined as a chart point or range that caps an increase in the level of a stock or index over a period of time. An area of resistance or resistance level indicates that the stock or index is finding it difficult to break above that price, and could head lower in the near term. So there is resistance to the price heading higher above a certain point.

Alternatively, support level indicates that the asset price over a given period of time has fallen below that price and there is an increase in buying activity at that lower price. In this instance the asset price could head higher.

Bearing the above in mind, divergence may then be a useful analytical tool in gauging market hysteria. In the case of “irrational exuberance,” or over optimism we would be seeing prices breaking through resistance levels, but the indicators would start to be moving in the other direction. Likewise, when there is excessive fear in the market a stock price might breach its support level, meanwhile the fundamental indicators might be all heading upwards.

So divergence might be a useful analytical tool for investors seeking value in asset prices.

Now let's apply this knowledge to the current state of the equity market. One view explaining the recent sell off is due to the concerns over divergences within and between markets, which may be taking a toll on investors' sentiment.

Could there be several factors occurring simultaneously in the market that is triggering the recent sell off.

There are several fear issues now at play. Firstly, investors are growing uneasy about the era of loose monetary policy coming to an end. The markets are becoming more anxious about rising interest rates. Higher interest rates usually causes capital outflows from equities, bonds and risky asset classes. Geopolitical concerns are growing, particularly with respect to the US led bombing campaign, which is targeting ISIS oil refineries inside Sierra, there has been collateral damage with civilian fatalities reported.

The fear is that this might lead to ISIS reprisals. For example, a potential terrorist attacks on civilian transport systems either in France, Britain or the US. With scores of radicalised Muslims cells in situ, this regretfully might not be too far fetched. The recent remarks by Iraq's prime minister only added to the fears, when he warned of a potential plots by Islamic State to launch terror attacks on subway systems in New York and Paris.

The Ukraine crisis, while there has been a de-escalation of tensions since the cease fire, sporadic fighting has been reported. So the situation could also deteriorate rapidly in the Ukraine particularly when the West is focusing its attention on the middle-east with its war on ISIS.

Moreover, earlier on in the week Small-cap stocks were hit. The under-performance of small caps has made headlines in recent months, but now the situation might be about to take a more serious turn. The Russell 2000, which is an index measuring the performance of the small-cap segment of the U.S. equity universe, is down 8.1 percent from a recent record, while the S&P is down less than 2 percent.

So we are seeing negative divergence in the equity market. But what about precious metals?

That's looking more like a positive divergence with asset price near year lows for silver and gold , simultaneously all the other fundamental indicators point in the other direction.

Gold, which has suffered a beating in September , rebounded from early losses to end 2.40 USD higher at USD 1,221.90 an ounce last Friday And silver, that other forgotten precious metal is now at an all year low of 17.6 USD.

“It is not clear what caused this sudden shock to the system, but it serves as a reminder about the dangers of complacency – especially for the bulls in the case of stocks and the bears in the case of precious metals,” said Fawad Razaqzada, technical analyst at Forex.com, in a research note.