Divergence in the major indices

Stocks continued to flex their
muscles yesterday, once again refusing to correct off their recent highs.
The Nasdaq Composite surged 1.6% yesterday, while the S&P 500 and Dow Jones
Industrial Average gained 1.0% and 0.8% respectively. Small cap stocks
outperformed with a 2.1% gain in the Russell 2000 Index. The S&P Midcap 400
Index jumped 1.5%. Each of the major indices trended steadily higher throughout
the session, then finished at their intraday highs. The rally was quite
broad-based, as none of the 24 major industry sectors we monitor closed in the
red. The Retail HOLDR (RTH) and Semiconductor HOLDR (SMH) both broke out above
their sideways consolidations that we pointed out in yesterday’s newsletter. The
streetTRACKS Capital Markets (KCE) snapped back from the prior session’s gap
down, so it did not trigger on the short side.

Total volume in the NYSE ticked lower by 2%, while volume in
the Nasdaq was about the same as the previous day’s level. While yesterday’s
gains were strong, the lighter volume tells us that mutual funds, hedge funds,
and other institutional players were not actively behind the buying. The stock
market can obviously rally without institutional participation, but the problem
is that stocks can reverse sharply when the bears step in if there is not
enough institutional demand to absorb the supply. Like we said a few days ago,
there is no reason to close your long positions as long as stocks are acting
well, but keep trailing those stops higher because each of the major indices
remain glued to the upper channel of their uptrend lines. When they eventually
correct, it could be fast and furious.

Unless you’ve been living in a cave, you already know that the
Dow Jones Industrial Average has been trading at a fresh all-time high for the
past week, but what about the “big picture” for the S&P 500 and Nasdaq
Composite? A record high in the Dow generates tons of media attention because
the index is a key psychological indicator for the general public. But the
reality is that the Dow is narrow-based index consisting of only thirty
blue-chip stocks. Historical charts have shown that relative strength in the Dow
without the S&P and Nasdaq keeping pace is usually short-lived. So, let’s take
an updated look at the long-term monthly chart of the S&P 500 to see how it
compares with the record high in the Dow. The best way to do this is by using

Fibonacci to measure the distance from its high:

Measuring the amount of the S&P’s retracement from its March
2000 high down to its October 2002 low, notice that the index has rallied right
into the 76.4% Fibonacci retracement level. When using Fibonacci, the 76.4%
retracement is considered the last line of defense that prevents a stock or
index from completely ripping to a new high (or falling to a new low if
measuring a downtrend). Typically, the 38.2%, 50%, and 61.8% retracements are
where most stocks will reverse and continue their prior trends. However, stocks
and indexes will sometimes rally all the way back to the 76.4% level if the
primary uptrend is strong enough. Because the S&P is sitting right at this
pivotal 76.4% retracement, there is minimal long-term technical resistance if
the index manages to break above its current level. Even though stocks may be a
bit extended in the short-term, the S&P will likely follow the Dow by blasting
off to a new all-time high if it can overcome this 76.4%
retracement level.

The Nasdaq has rallied a whopping 112% off its October 2002
low, but even more amazing is that the index has not even made it back to its
38.2% retracement of the selloff from March 2000 high down to its October 2002
low:

If you were involved in the markets in the late nineties, you
surely remember how insane those days were, and the drop that followed was just
as crazy! As such, it’s not surprising that the Nasdaq is still 54% off its
all-time high. Though the Nasdaq is finally nearing its 52-week high, many of us
may never even live to see a new all-time in the Nasdaq.

While we’re looking at the monthly charts, let’s not forget
everyone’s friend, the Dow. When an index or stock is at a fresh record high,
there is absolutely no overhead supply from people who bought at higher prices
and are selling into strength. This, of course, is the reason that stocks and
indexes at new 52-week highs can easily go higher without much buying pressure.
However, we can use a Fibonacci extrapolation beyond the 100% retracement to
predict an upside price target and the next major band of resistance in the Dow.
In doing so, you will see that the 123.6% retracement is the next price target
in the Dow, assuming it holds at its new high:

Comparing the monthly charts of the “big 3” indices, the
divergence is pretty interesting. We’ve got the Dow at an all-time high, the S&P
trailing with a rally into its 76.4% Fibonacci retracement, and the Nasdaq still
in the bottom third of its range. As short-term traders, these monthly charts
don’t matter much because the time interval is too long for it to matter much.
Nevertheless, understanding the “big picture” helps you to maintain an overall
healthy perspective on your short-term trading activities. Noting the divergence
between the major indices also tells us which ones are likely to lead the way
lower when we reverse back down. Buy sectors and indexes with relative strength
and sell short those with relative weakness.

Open ETF positions:

Deron Wagner is the head trader
of Morpheus Capital Hedge Fund and founder of Morpheus Trading Group (morpheustrading.com),
which he launched in 2001. Wagner appears on his best-selling video, Sector
Trading Strategies (Marketplace Books, June 2002), and is co-author of both The
Long-Term Day Trader (Career Press, April 2000) and The After-Hours Trader
(McGraw Hill, August 2000). Past television appearances include CNBC, ABC, and
Yahoo! FinanceVision. He is also a frequent guest speaker at various trading and
financial conferences around the world. For a free trial to the full version of
The Wagner Daily or to learn about Deron’s other services, visit
morpheustrading.com
or send an e-mail to
deron@morpheustrading.com .