The Dow Pulls Ahead

The blue-chip benchmark's recent outperformance may signal that investors are starting to get a bit more defensive

From Standard & Poor's Equity Research

The Dow Jones industrial average broke out to its highest level since June, 2001, last week, and has taken a leadership role over both the S&P 500 and the Nasdaq over the last couple of weeks. Bonds, despite rallying on Friday, Feb. 17, stayed within the confines of a very narrow range. Oil prices reversed to the upside on Thursday and Friday after getting hit hard earlier in the week.

The DJIA, which always gets a lot of press when it approaches big round numbers, broke back above 11,000 last week, finishing at 11,120.70 on Thursday, Feb. 16. This was the highest close since June 5, 2001. While that might sound impressive, remember that the DJIA has been stuck in a range between 7400 and 11,800 since the middle of 1997. What would be impressive, in our view, is if the DJIA can break out of its almost decade-long trading range, taking out the all-time closing high of 11,722.98 from back on March 24, 2000.

What caught our eye last week concerning the DJIA was that the index ran up to some key pieces of trendline resistance on Thursday. Similar pieces of trendline resistance are evident on the S&P 500 and Nasdaq charts, and have worked well at creating short-term ceilings for those indexes. Short-term trendline resistance, drawn off the recent peaks in November and January, came in right near the DJIA's close on Thursday. Another longer-term trendline, drawn off the peaks in 2004 and 2005, also may have provided a ceiling for the DJIA this week. Both trendlines come in between 11,120 and 11,140.

The DJIA's chart formation is also taking on a similar look when compared to both the S&P 500 and the Nasdaq. The Dow has put in a series of higher highs and lower lows since late November. This formation is known as a broadening top, and if the index breaks down and completes this formation, the pattern can represent either an intermediate-term or long-term reversal.

The S&P 500 shot up and looks poised to challenge the recent closing high of 1294.18 posted on Jan. 11. On Thursday, the S&P 500 jumped above trendline resistance drawn off the two recent peaks in January. During the week, the index was able to recapture the 10-day and 20-day exponential moving averages. The series of lower highs and lower lows has also been busted. However, a breakout above the recovery high might not have far to go, in our view, as trendline resistance off some of the recent peaks comes in at 1305 and 1310.

On the downside, the S&P 500 has near-term chart support at the recent low of 1255. Intermediate-term chart lies at 1246, and we believe a close under this level would be quite negative and be a sign that a major correction was in the cards. The 50-day exponential moving average is at 1266, while short-term trendline support comes in at 1261.

If the S&P 500 does move to marginal new highs, we think many of the daily and the weekly technical indicators are setup to trace out negative divergences. For instance, both the 6-day and the 6-week relative strength index (RSI) have put in a series of lower highs since the end of November, and we think that unless the S&P 500 blasts out of the current consolidation, another lower high in RSI will be traced out.

Since the end of January, the S&P 500, Nasdaq, and the Russell 2000 have all underperformed the DJIA. We believe that the DJIA is doing better than the other, more volatile indexes, because investors are starting to get a bit more defensive. This has led to at least a short-term move into larger capitalization stocks. While this two to three weeks of outperformance by the DJIA is certainly not long enough to be defined as a trend, it may have negative implications.

Taking a step back, we find that the S&P 500, Nasdaq, and Russell 2000 have all outperformed the DJIA on a consistent basis since 2002. The last time the DJIA was in a leadership position for any length of time was from 2000 to 2002, which just happens to coincide with the last bear market. Moving back to a shorter-term view reveals the same kind of pattern. There have been periods (months) over the last couple of years when the DJIA has outperformed the other indexes. During these periods, we saw pullbacks or corrections in the overall stock market. So if we are in one of those short-term periods of leadership by the DJIA, we would not be too concerned. If however it becomes a pattern longer than a couple of months, we would then become very cautious.

Treasury bond prices had a decent rally on Friday, dropping yields from their recent highs. The 10-year yield has remained between 4.4% and 4.6% since the end of January, a very narrow range in our view. Bond prices had moved to an oversold condition on a daily basis so a countertrend rally is not surprising. Bond yields also moved up near 4.7%, where there is heavy, long-term chart support. Since June, 2005, bond yields have traced out a series of higher yield highs and higher yield lows.

However, since July 2003, 10-year yields have remained in a massive sideways pattern between 3.6% and 4.9%. For the majority of that time, yields have been confined to the 4% to 4.7% zone. We still believe yields are tracing out a massive, long-term bottom, but in our view, a reversal in yields to the upside will not occur until long-term trendline support is taken out up near the 5% level. This trendline is drawn off the peaks in yields going all the back to 1987.

Crude oil prices had a volatile week, falling from $61.84 on Friday, Feb. 10, to $57.65 on Wednesday, Feb. 15, before rallying to close the week at $59.88. From the Jan. 30 close of $68.35 to the closing low on Wednesday, crude oil had plunged over 15%. This is the worst 12-day price performance by crude oil since December 2004. Prices fell to some key pieces of support this week in the $55 to $57 area. In addition, oil is very oversold on a daily basis. We therefore expect crude to bottom out in the near term, and begin another run higher.


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