Ask Colin

Should I buy a stock if the market is showing a bearish divergence?

In general, the question you are asking is how much weight should be put on the analysis of the individual stock compared to the market as a whole and to what extent the market analysis should influence your decisions on a stock.

Your question poses a number of issues:

1. Divergences. I don't like using them. The reason is simple - there is often a divergence at a change in trend. However, there are many divergences that do not signal changes in trend, but merely the effect of the longevity of the trend or a slowing down in the momentum in the trend. Many trends start off quickly and then slow down, yet go on for some time. In fact this is healthy. The divergences that occur in these situations are best avoided, because the signals are far too early.

The way you can try to resolve this is to only act on a divergence if it is accompanied (usually in fact followed by or confirmed by) a longer term trend following indicator like a moving average.

2. The role of market analysis. I take the view that the analysis of the market should be kept separate from analysis of individual stocks. For me the propose of analysing the market is to drive your decisions on your exposure to the market (asset allocation in industry jargon). So, I analyse the market to try to determine where we are in the cycle of Dow Theory phases and so to assess the general level of risk.

I have explained my approach to this in detail in Shares Charting Guide Issue No 2 March to August 2003 and also in my videotape Building Wealth Through Shares, details of which are on my web site www.bwts.com.au.

3. The role of individual share analysis. Having decided your level of market exposure, you will be wanting to either buy more stocks or not.

The buying decision should be made solely on the analysis of the individual stock. You should only be looking to buy a stock if your market analysis suggests increasing exposure. So, now you have two decisions to make: What stock to buy and when to buy it. Essentially, you follow your investment plan for these decisions.

Bear in mind that most stocks are affected by the direction of the overall market. This will usually be indicated in your analysis of the individual stock. Depending on whether you are a trader or an investor, you will put more or less weight on short term timing.

However, I think that more mistakes are made by relying overly on the market analysis than on the analysis of the individual stock. There are two main mistakes that are made:

First, on selling. The stock gives you a sell signal. You ignore it because the market is strong or looks ready to rally. Big mistake. If your investment plan indicates selling the stock, you act on that without reference to the market overall.

Second, on buying. The stock gives a buy signal. The market looks overbought or due to correct. If the stock says buy and the market says wait, I would buy the stock. There are always many reasons not to pull the trigger on your plan. It results in many missed opportunities.

What I am saying here is very like the divergence argument. Most stocks take their short term direction from the overall market. However, there are always some stocks moving against the market. These are in fact often the best ones if they are giving strong buy signals in a falling market.

The only caveat to this is if you are a short term trader. For an investor, I don't think the direction of the market matters much. But for a short term trader, it is far more important. The stock may still go up against the market, but it will not go up as much. Since the margins for error are so much smaller on short term trading, you might want to have the stock and the market both in a bullish set up before you buy, just as you will want both the big trend and the short term trend in the stock both turning bullish at that time.

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