Don't Ignore This Market Divergence

Editor's note: Most investors are hopeful that the Federal Reserve will start cutting rates this year. But according to our colleague Greg Diamond, we should be watching the price action to get a clearer sense of what's ahead. In this piece – which we've updated from a recent issue of Ten Stock Trader – Greg highlights two parts of the market that are diverging today... and explains what this means for investors.

Bond traders are the smartest people on the trading floor...

Or at least that's how the old saying goes on Wall Street.

The bond market tends to move based on economic developments – like higher or lower inflation – sooner than stocks do.

Bonds are more focused on overall economic health in the future... whereas the stock market can be driven by emotion and positioning.

Simply put, stocks and bonds both do a good job of discounting future economic developments, but bonds are usually ahead of the game.

Now, inflation has been a hot topic among investors lately. And for good reason...

We've experienced record-high inflation over the past few years. As these figures come back down to "normal" levels, stocks have rallied to reflect lower inflation and the possibility that the Federal Reserve could cut interest rates.

But what about the bond market?

Do bond prices suggest that the "smartest people" on Wall Street's trading floors share in the optimism that rates will come down this year?

Today, I'm going to look at bond prices. We'll see how they're behaving, both on their own and relative to the stock market.

The relationship between stocks and bonds may be sending investors a warning sign. Let's get started...

I've recently discussed tactical trading and how we can apply this to our game plan in both the short and long term.

I'll continue to look for short-term trading opportunities... But we also need to watch for trend changes, which could come in the form of price divergence between bonds and stocks.

And this divergence could happen quickly...

Here's a chart of the Nasdaq 100 Index and the iShares 20+ Year Treasury Bond Fund (TLT), which holds a basket of long-term Treasury bonds...

Take a look at the vertical red line above... Since late December 2023, TLT has traded down while the Nasdaq 100 has traded up.

As you can see, this highlights a widening divergence within the market. And it's flashing a warning sign for investors...

When bonds top out and stocks keep rallying, the inflationary picture may not be as rosy as stock investors think it is.

Now, based on technical analysis, we're looking at this possible setup below...

You'll notice five numbers marked in red on this chart. This is a classic Elliott Wave pattern that helps technical analysts plot a move up or down in a market or asset.

As you can see, wave (5) is at the top of the trend line. This tells us that the move up in TLT is complete. So the solid blue line represents a possible road map for what could happen in TLT over the next few months.

Now, the price action may not look exactly like this. But with stocks rallying to new highs and TLT not confirming that rally (given its lower high), the upside in stocks could be limited as bonds show that a top is likely in place.

This possibility poses some risk ahead...

So far this year, investors have been acting as if inflation has peaked. Most want to believe the Fed will keep interest rates steady – or begin cutting rates – in the months ahead.

But what if the crowd has this bet wrong?

Just take yesterday's Consumer Price Index report. January inflation rose 0.3% from December and 3.1% from a year ago. Both increases were higher than expected.

What if inflation remains "sticky"? What if we see higher-than-expected readings that fail to confirm the consensus that inflation will fall well below the 2% level (one of the Fed's goals)?

Or what if the Fed gets it wrong? It has happened before... The Fed got "transitory" inflation wrong back in 2021 and 2022. And more famously, it got the "subprime is contained" idea wrong just before the 2008 housing and financial crisis began.

I won't speculate on what the Fed will or won't do this year. But either scenario introduces risk to the market. That means traders need to be flexible today.

In short, we can't ignore the divergence we're seeing between bonds and stocks. It's a potential warning sign. And it's another reason why now is a good time to trade tactically.

That means I'll be looking for short-term opportunities in stocks and bonds... in both directions.

Good trading,

Greg Diamond, CMT

Editor's note: Greg's technical analysis allowed him to accurately predict the COVID-19 crash, the 2022 market crash, and last year's rally. Now, he's warning investors about a major turning point that's about to take place in the market. This move could take a lot of folks by surprise... with disastrous consequences. But if you're prepared, it could be your best opportunity to position yourself for quick gains in 2024... Click here to learn more.

Further Reading

It takes time to successfully cultivate a trader's mindset. But by following three specific steps, you'll eventually be able to overcome the many "hurdles" the market throws your way... Read more here.

Patience is key when it comes to investing. Investors who know when to play "offense" and "defense" will make smarter trading decisions than those who blindly jump in... and will stand a better chance of avoiding big losses, too... Learn more here.