Nasdaq: Lagging the Blue Chips

While the Dow and S&P 500 move near recovery highs, the tech-heavy index is still trying to break out of its short-term downtrend

From Standard & Poor's Equity Research

The Dow Jones industrial average was able to climb to a new recovery high last week, the S&P 500 got very close, while the Nasdaq is still trying to break out of its short-term downtrend. Bond yields drifted sideways for the fourth week in a row, while crude oil tested the recent lows and broke out of a small base.

The S&P 500 closed at 1292.67 on Wednesday, Feb. 22, coming very close to its January recovery high of 1294.18. Since Nov. 21, the S&P 500 has remained rangebound between 1246 and 1295 as neither the bulls or the bears can take control of the market. On the downside, the S&P 500 has plenty of support levels that have created a floor underneath current levels. The 50-day exponential moving average sits at 1270 with short-term trendline support at 1270 and 1261. The 80-week exponential moving average comes in at 1261. Chart support is at 1255 and 1246.

On the upside, minor chart resistance sits at the recent high of 1294. In our view, if the S&P 500 can break to a new recovery high, there is trendline resistance just overhead that could limit any immediate gains. A trendline off the December, 2004, March, 2005, and January, 2006, peaks comes in at 1305. Trendline resistance, drawn off the highs in August, 2005, and January, 2006, is at 1312, while a trendline off the November, 2005, and January, 2006, highs lies at 1325.

The danger, in our opinion, of another minor high by the S&P 500 is that it would set up another negative divergence with respect to many daily momentum indicators, as well as some weekly momentum indicators. For instance, the 14-day relative strength index (RSI) put in a peak on Nov. 25 at 74, a secondary peak on Jan. 11 at 70, and a third peak at 61 on Feb. 22. The same pattern can be seen with the 6-day RSI. Looking at the weeklies, the same pattern emerges, with the 6-week and 14-week RSI tracing out a series of lower highs.

What this says about the stock market, in our view, is that there has been a loss of momentum on both a short-term and intermediate-term basis. While that does not always mean the market will ultimately pullback or correct, it does bear watching.

The Nasdaq has been unable to shake out of a pattern of lower highs and lower lows that started after posting its new recovery high on Jan. 11. The Nasdaq has been underperforming the S&P 500 and the DJIA for the entire month of February. Along term pattern of underperformance by the Nasdaq would, in our view, be negative for the overall stock market. Often, when the DJIA lead the market and the Nasdaq under performs, the overall market is in a correction or a bear market. It represents a defensive posture by institutions and individual investors as they seek the safety of large capitalization issues.

Market sentiment is mixed, in our opinion, as the recent strength in the stock market has moved option investors back to the bullish camp, while investment polls such as Investor's Intelligence has worked off its bullish fervor. Put/call ratios tend to trend with the stock market. As the market moves higher, put/call ratios generally will decline. As the market corrects, put/call ratios will generally rise.

We look for two distinct elements when evaluating put/call ratios; the absolute ratio versus historical norms and intermediate-term turning points in the ratios. For instance, the 10-day, equity-only put/call ratio has dropped to between 0.53 and 0.49 before the last three market pullbacks. Just recently, the 10-day fell to 0.53, so when just looking at this indicator, the chances for at least a market pullback have risen, in our view. During the middle of February, after getting this low put/call reading, it appeared that the trend of the ratio had turned higher and that a pullback was starting.

However, with the latest market strength, the 10-day ratio has dropped back down, and the turn in trend has at least been postponed. When the put/call ratio turns higher on an intermediate-term basis, a couple things happen which causes the market to change direction and head lower. Option investors generally sell their bullish call positions and buy bearish put positions. This shift in the options market can weigh heavily on the market.

Investor's Intelligence poll of newsletter writers has seen a decent size decline in bullishness over the last two months, despite the lack of a correction, and may be indicating that stocks have further to run on the upside. We look at investment polls the same way we look at put/call ratios. We look at absolute levels of bullish or bearish sentiment and compare these levels historically. We also look for turning points in poll sentiment. The latest readings from this poll show 45.3% bulls and 29.5% bears. These are the exact same readings we saw in the middle of October, when the market was bottoming.

From a long-term perspective, major market lows often occurred when bullish sentiment equaled or fell below bearish sentiment. There is no reason why there could be a further contraction in bullishness in this poll, but we will monitor it for a trend change that may indicate an extension of the current intermediate-term advance.

Crude oil prices did some testing of the recent lows last week before breaking out of a small base on Friday, Feb. 24. The intraday low for the week occurred on Thursday when crude oil hit $59.70 per barrel. This test on Thursday brought crude oil back into an area of chart support between $57.50 and $60. On Friday, crude surged $2.26, finishing the week at $62.91, up 5% for the week.

The recent correction in crude oil took prices down to trendline support off the lows in 2004 and 2005. We believe this trendline is very important because it has been tested four times over the last couple of years and has held each time. The more times a trendline is tested and holds, the more importance it takes on. Crude oil also fell back to its 65-week exponential moving average, which has also acted as good support over the last couple of years.

Daily momentum indicators, after reaching oversold levels in the middle of February, have turned higher and given buy signals. Oil has already retraced over 38.2% of its decline during the first half of February. The next two Fibonacci targets would be a 50% retracement that lies at $63.27 and a 61.8% retracement at $64.63.


S&P STARS: Since January 1, 1987, Standard & Poor's Equity Research Services has ranked a universe of common stocks based on a given stock's potential for future performance. Under proprietary STARS (STock Appreciation Ranking System), S&P equity analysts rank stocks according to their individual forecast of a stock's future capital appreciation potential versus the expected performance of a relevant benchmark (e.g., a regional index (S&P Asia 50 Index, S&P Europe 350 Index or S&P 500 Index), based on a 12-month time horizon. STARS was designed to meet the needs of investors looking to put their investment decisions in perspective.

S&P Earnings & Dividend Rank (also known as S&P Quality Rank): Growth and stability of earnings and dividends are deemed key elements in establishing S&P's earnings and dividend rankings for common stocks, which are designed to capsulize the nature of this record in a single symbol. It should be noted, however, that the process also takes into consideration certain adjustments and modifications deemed desirable in establishing such rankings. The final score for each stock is measured against a scoring matrix determined by analysis of the scores of a large and representative sample of stocks. The range of scores in the array of this sample has been aligned with the following ladder of rankings:

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