Correction Dead Ahead?

The slumping Nasdaq could drag the rest of the market lower over the near term

By Mark Arbeter

The Nasdaq composite index, which has been underperforming the blue chip indexes over the last month, traced out a nasty reversal on Thursday, Feb. 19, and could drag the rest of the market lower over the near term. Volume was heavy Thursday, giving more credence to the potential for further losses.

The tech-heavy Nasdaq sliced right through its 50-day exponential moving average at 2,046 on Friday, Feb. 20, undercutting this important support line for the second time since the beginning of February. This support line has provided a floor for the Nasdaq ever since the index took off in March, 2003. While a break below the 50-day moving average for a day or two is not critical, it does raise the caution flag once again. The break of the 50-day in conjunction with clear signs of distribution on the Nasdaq, along with an ugly looking chart pattern, may suggest that the long-anticipated correction is finally here.

On the daily chart, the Nasdaq has traced out a lower high for the first time since July, and looks vulnerable after its torrid advance since last March. The next key short-term support level for the index is at 2,014 or the closing low posted on Feb. 4. Below that level, chart support begins at 1,990 and is fairly heavy down to the 1,880 area. An initial Fibonacci retracement of 23.6% of the increase since March comes in at 1,945.

Another index that has a fair amount of influence on the overall Nasdaq, the Philadelphia Semiconductor Index (SOX.X ), also looks toppy on a chart pattern basis. The SOX is potentially tracing out a bearish, head-and-shoulders top formation. The neckline of the H&S top formation and the area that must break for the SOX to complete this pattern currently lies at 500. If this were to occur, it would then target the 420 zone for the SOX or a 25% correction from the January high and 17% below current levels. From Feb. 7 until Jan. 12 of this year, the semiconductor index soared 115%, so it is certainly due for a decent-sized correction.

The biotechnology stocks, another big component of the Nasdaq, have taken over leadership from the semiconductor stocks recently. The AMEX Biotech Index (BTK.X ) has outperformed the SOX over the last 3 months (after underperforming for almost 5 months) and the chart of the BTK looks much more constructive than the SOX. However, and like the SOX, the BTK has run into a heavy area of chart resistance from back in 2001 and 2002. This resistance should probably keep a lid on the BTK over the near-term.

The S&P 500 is not in as much danger as the Nasdaq but additional losses could certainly occur. A close below 1,126.52, or the most recent low, would complete a minor double-top formation for the "500" and would target the 1,095 level. There is also a major trendline in this area, which has been tested twice already. Other support areas for the S&P 500 come from the 50-day exponential moving average at 1,120 and chart support that begins in the 1,080 zone. A 23.6% retracement of the gains since March would target 1,074.

Market sentiment continues to lean heavily to the bullish camp, with the major investor polls, put/call ratios, and volatility indexes at or near short- to long-term extremes. Investor's Intelligence poll of newsletter writers recently moved to its most bullish position since this past summer. Bullish sentiment is up to 59.2%, the highest since June, and bearish sentiment has fallen to 17.3%, or the lowest since mid-July. The market just happened to consolidate for two months from June to August. Bullish sentiment on this poll has been over 50% and bearish sentiment has been below 25% for an incredible 42 straight weeks.

Put/call ratios on the CBOE are hanging near their lowest levels in a couple of years, despite the recent weakness in the market. The VXO (VXO.X ) or volatility index of the S&P 100 index has been trading in the 15 to 17 range of late, or the lowest level since back in 1996. Downside momentum on the VXO has flattened out and may indicate that the index has finally bottomed after falling on a fairly consistent basis since last March. A turn higher in both the VXO and option ratios would not be a good sign, and it certainly bears watching. Major turns higher in both volatility indexes and put/call ratios have usually coincided with market corrections.

The U.S. Dollar Index rose sharply on Friday, Feb. 20, and is very close to completing a bullish, double-bottom formation. A close above the 87.71 level or the recent high, would complete this formation and then target the 90 zone. There is major trendline resistance up near 92, and considering the size of the decline in the index and the time it took since peaking back in 2002, we would expect a fairly wide base before a new bull market in the dollar can take place.

Due to the strong rise in the dollar on Friday, Feb. 20, gold prices plunged and are back testing the recent lows just under the $400 per ounce level. The gold chart looks very toppy and it would not be surprising to see a correction back to the $370 to $380 area. There is chart support in this zone and it would also represent a 50% retracement of the advance since March.

The 10-year Treasury note failed to break through the 4% level on a closing basis last week and backed up to 4.10% on Friday, Feb. 20. The 10-year note has remained in a trading range since July, and this range is slowly narrowing, indicating a decrease in price volatility. The compression in volatility of any market is usually resolved in a big move, one way or the other. Important yield levels to watch are 3.91% on the downside and 4.3% to 4.4% on the upside. When the 10-year note breaks one of these areas, it is likely to see a decent sized move in the direction of the break.

Arbeter, a chartered market technician, is chief technical analyst for Standard & Poor's

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