Nasdaq leads the decline; Dow Theory divergence and small cap weakness bear watching

As equities take their first noticeable breather since mid-November, it is noteworthy to observe the relative weakness in the Nasdaq compared with the S&P500. The Nasdaq's swift correction in relative strength (the composite fell 2.39% on the week vs. .76% for SPX) is its most extreme since equities rallied off their September lows.  Some frothiness in technology and a few bad apples in the earnings mix proved enough to shake the bulls from their perch in this sector of the markets.  See the chart below:

Nasdaq breadth indicators swiftly fell to levels achieved at the lows in November. Stocks trading over their 50-day moving average fell over 10% to 70%, nearly matching the level seen at the bottom of the pullback in November's 5% rout.  Although this respite in bullish frothiness was needed, it was met with light volume, a positive reinforcement of the bullish uptrend and perhaps enough to entice some nibblers to buy.  See the chart below:

In fact, we focus on the Nasdaq and its relationship to its former high at 2,859 achieved on Halloween 2007. A decisive break of this high (another 6% to go) will reinforce the bullish trend and coerce other equity indices to follow along.

Moving on to other sectors and styles, we have found some curious changes that bear watching.

The Dow Jones Transportation Index took a hit this week, printing a divergence from the Down Jones Industrials. This is the first significant divergence in Dow Theory seen since the September bottom and bodes watching. There was no single culprit in the transportation index decline, spread across airlines, ground and maritime shipping.

As for style, this week we saw a noteworthy correction in the relative strength of small caps vs. large caps, a larger hit that the one we saw in November. This could be normal profit-taking in the frothier side of the market in favor of more conservative equities. Although the uptrend in small caps vs. large caps remains intact, watch for style rotation as the significant market gains from the March 2009 bottom begin to wear. Small cap outperformance peaked about 18 months before the S&P500 peaked in October 2007. This could suggest the need for large caps to "catch-up" to the performance of small caps before this Bull run is over. See the chart below:




Reviewing our sentiment readings, our Put/Call alert flashed last week came to fruition as the low seen had in the past preceded market declines.  See out chart below (from last week's blog):

Today, this indicator reads neutral-slightly bearish at .79.  VIX similarly printed an extreme reading last week and preceded the pullback as noted in this blog. Today, VIX crossed above its 50-day moving average, eliminating the "risk gap" we have noted before. Based on past market behavior, VIX could see some more upside (and equities some downside) before a modest "November-like" correction is over.

As the uptrend remains intact, we suggest holding off with new buys until some basing is seen. In the November correction, prices took a hit quickly then stabilized; in November, our indicators resolved themselves to the bullish camp rather quickly after the first few days of declining prices. Watching price and our indicators this week will play an important role in assessing the health of the Bull run.

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