How I measure the market’s health

Tuesday was a session of broad market
divergence, as small and mid-cap stocks sold off sharply, but the
blue chips of the Dow eked out a nominal gain. The small-cap Russell 2000
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and S&P Midcap 400 \MDY|MDY] indices both drifted lower throughout the day and
sustained losses of 1.4% and 1.2% respectively, while the Nasdaq Composite
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slid 0.8%. Confined buying interest in the final thirty minutes helped lift the
S&P 500
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Industrial Average
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0.2% gain.

Total volume in the NYSE declined by 2% yesterday, while
volume in the Nasdaq was 11% lighter than the previous day’s level. The fact
that yesterday’s losses occurred on lower volume could be construed as a
positive, but remember that three “distribution days” in both the S&P and Nasdaq
have already occurred within the past week. Despite the decrease in turnover,
market internals were firmly negative. Declining volume in the NYSE exceeded
advancing volume by a margin of 5 to 2, while the Nasdaq’s ratio was worse at
nearly 7 to 2. This tells us that even though stocks may not have sold off on
heavy volume, overall volume was a lot heavier on the downside than the upside.

After the close of trading, we noticed that many of the
popular financial web sites were saying it was positive that the Dow bucked the
trend and closed higher yesterday. This, of course, is not surprising because
the financial press always has a tendency to portray a positive slant to each
day’s action, regardless of the actual outcome. The reality, however, is that
yesterday was pretty nasty overall. The biggest concern was the major relative
weakness in nearly all the market leading stocks. Although the giant blue chip
corporations such as Intel, Wal-mart, Microsoft, and Pfizer have huge market
caps, they are no longer considered to be “market leaders” because their
aggressive growth years have passed long ago. Instead, the performance of
today’s market leading stocks such as Marvell Technology, Google, Hansen
Natural, and SanDisk is much more an indicator of the market’s health. This is
so because the direction of aggressive growth stocks historically tends to lead
the market in both bull and bear markets. When many market leading stocks are
registering huge gains and consistently climbing to new highs, the broad market
tends to follow. Conversely, the broad market often drops sharply after the
market leaders begin to fall apart. Unfortunately for the bulls, the latter
scenario is what we see happening right now.

In addition to weakness among market leading stocks, we have
also lost leadership among the semiconductor sector. When the former market
leading sectors such as oil, gold, and utilities began to correct earlier this
year, new leadership soon followed with strength in the semiconductor and
computer networking sectors. However, the Semiconductor Index ($SOX) has fallen
6% over the past three days. More importantly, the $SOX closed yesterday below
its 50-day moving average for the first time since last November. Obviously, the
$SOX has quickly lost its former relative strength as well. Therefore, unless
new sector leadership soon emerges, we don’t expect much broad-based strength.

Because market leading stocks are often in the “mid-cap”
category, the cumulative performance of that group is often represented by the
S&P Midcap 400 Index. Similarly, the small-cap Russell 2000 Index has been a
market leader for the past several years and is presently a more accurate
barometer of the broad market’s health than the Nasdaq Composite. This is the
reason we always report on the daily performance of both the Russell 2000 and
S&P 400, even though the general financial media tends to ignore these two very
important market indices. If you look at yesterday’s performance in MDY, the
popular ETF that tracks the S&P 400, you will understand why we feel the broad
market may be in for a substantial correction:

As you can see, MDY broke support of its steady 5-month
uptrend line and finished below its 50-day moving average for the first time
since the primary uptrend began back in October 2005. IWM (iShares Russell 2000)
is still above its 50-day MA, but broke support of a three-week band of
consolidation. As such, we would not be surprised to see IWM follow MDY in
breaking its 50-day MA in the coming days. If you are looking for a new short
entry in one of the broad-based ETFs, you may want to consider either MDY or IWM.
We shorted MDY on February 21 when it formed the right shoulder of a bearish
“head and shoulders” pattern, but we were a bit too early and stopped out on
February 27. Nevertheless, a re-entry in MDY short is now much lower risk
because it has confirmed its initial signs of weakness by falling below its
50-day MA and primary uptrend line. As long as MDY stays below its former
uptrend line, which is now the new resistance level, we view any intraday bounce
as a chance to sell short into strength.

As for the S&P 500, it is now sitting at a crossroad and
traders will be forced to decide whether the index “makes it or breaks it” from
here:

After probing below its 50-day MA yesterday afternoon, notice
how the index recovered into the close and finished right on the 50-MA. It’s
also interesting to note that yesterday’s low coincided with support of the
daily uptrend line as well. Therefore, the S&P 500 should either fall apart from
here or reverse off support of the uptrend line and 50-day MA. In
addition to weakness in the market leaders that we discussed above, it is
bearish that the S&P recently failed to breakout from its consolidation at its
prior 52-week high. Instead, it fell back down to its 50-day MA after trading
above it for only three weeks, leaving a potential “double top” formation on the
daily chart. Now if we knew for certain whether the S&P will collapse
below support or reverse and rally off its 50-MA, we would be billionaires by
now. We can, however, increase our odds of being on the right side of the market
by taking an objective look at all the technical aspects of the current market
environment. In doing so, we certainly feel that overall odds favor the short
side of the markets.