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As Value Line diverges, which period of history will we repeat?

It benefits to pay attention when the Value Line indices – which track the large cap S&P 500 – diverge, as Andrew Thrasher shows.

Equities have been trending higher after breaking out from their multi-week consolation with the S&P 500 nearing its prior summer high. Several breadth, momentum, and risk appetite indicators have done a nice job confirming the trend along with some participation by small caps and financial stocks which seemed like they had been left for dead as Treasury yields put a choke hold on their trend. 

There’s a set of two indices that have caught my eye recently that have not been doing a great job confirming the bullish price action in US large caps though: Value Line indices.

 

What are the Value Line indices?

The Value Line indices were originally created in 1961 and represent over 1,700 publicly traded stocks from the NYSE, Nasdaq, Toronto Exchange, and American Stock Exchange. The Value Line Geometric Index is equally weighted and due to the size of the coverage, can provide excellent insight into the equity market that may not be shown by the more popular indices. 

“The Value Line Geometric Index is equally weighted and due to the size of the coverage, can provide excellent insight into the equity market that may not be shown by the more popular indices"

Typically, both Value Line indices track the large cap S&P 500, which means when they diverge we want to pay attention since it doesn’t happen very often. We last saw a divergence when the S&P 500 made a higher-high last October, with both Arithmetic and Geometric Value Line indices making lower-highs. This is also what many other breadth and market gauges were showing at the time as participation in the up trend narrowed severely while volatility also contracted to historic levels. Stocks then began to confirm the weakness and we had the Q4 down trend.

As the S&P 500 bounced in December of last year and went on to set a new all-time high, Value Line indices have continued to make lower highs, not nearly showing the same degree of strength. What’s telling about this divergence is just how long its lasted. With each new high in the S&P 500, the Value Line indices have gone lower and lower – even setting a lower-low under the prior April level with the most recent dip in stocks.

 

Two other divergences in the Value Line

If we go back a little further in history, we can see two previous divergences, both with very different outcomes. In 2011 stocks produced a double-digit decline, but when the S&P 500 recovered it did not immediately see confirmation in the Value Line indices. This divergence was concerning but eventually resolved itself to the upside and the Value Lines eventually began to confirm the price action in the S&P 500. 

The second divergence takes us back to 2007. The S&P 500 made a higher-high, but we saw lower-highs in the Value Line – this was followed by the financial crash.

 

What happens next?

Will the divergence in the broad focused, 1,700+ stock Value Line indices fix itself and begin tracking with the large cap equity index once again or are we in for something more severe? 

Time will tell. Right now, I’m not seeing other major breadth divergences to the degree we had in 2007, which is a good sign. I’m keeping an open mind and always looking for where the greatest degree of risk is within the financial markets. 

I’d like to see the Value Line indices break above their most recent prior highs, which is marked by blue lines on the first chart. That would be a great first step in getting back to confirming what the other major equity indices are doing.

 

By Andrew Thrasher, who serves as the portfolio manager for the Financial Enhancement Group, a wealth management firm in Indianapolis, Indiana, and is also the founder of Thrasher Analytics, an institution research firm.

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