One of the biggest challenges facing stocks right now

For the third day in a row, a morning
rally attempt fizzled out, causing the major indices to trend lower
and finish near their intraday lows. The S&P 500 and Dow Jones Industrial
Average
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weakness in the tech arena continued to weigh on the Nasdaq. Despite the
small-cap Russell 2000 Index
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still slid 0.6%. The S&P Midcap 400 lost 0.2%, aiding our new short position in
the S&P Midcap SPDR
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The one bright spot of yesterday’s session is that turnover
declined across the board. Total volume in both the NYSE and Nasdaq was 10%
lighter than the previous day’s levels. This enabled the Nasdaq to avoid another
“distribution day” that signifies institutional selling. Still, many leading
stocks continued to fall below their breakout levels and a few even broke major
support levels. Market internals were marginally positive in the NYSE, but
declining volume exceeded advancing volume in the Nasdaq by a margin of 7 to 2.

One of the biggest challenges facing stocks right now is the
major relative weakness in the Semiconductor Index
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the broad market, the $SOX has been in a steady downtrend since the beginning of
May, but the big difference is that the index failed to recover when the major
indices bottomed in mid-June. To illustrate this, take a look at the overlay
chart below that shows the percentage price change of the S&P 500 versus the
$SOX since the June 13 low:

 

Since the broad market formed its intermediate-term bottom on
June 13, the S&P 500 has gained 3.5%, but the Semiconductor Index has fallen
4.3% since then. Notice how the $SOX failed to rally above its prior high along
with the S&P at the end of June. That was a major sign of continued relative
weakness in the sector, which explains why the $SOX quickly fell to new lows
when the S&P pulled back off its highs over the past week. The basic law of
relative strength states that sectors and stocks that fail to rally when the
broad market does are always the first to fall on any subsequent weakness in the
market. The chart above is a great educational example of this.

As you may know, the direction of the $SOX is always important
because the sector is so heavily weighted within the Nasdaq. Most of the time,
the $SOX acts as a leading indicator for the direction of the Nasdaq, which in
turn tends to lead the rest of the broad market. Unfortunately, the longer-term
view of the $SOX is equally negative. Looking at the weekly chart, notice how
the $SOX just broke below its October 2005 weekly closing low AND its 200-week
moving average. Needless to say, this should be a major concern for the bulls:

Although the S&P and Dow are still holding up okay, the Nasdaq
is starting to look ugly again and will inevitably begin to weigh on the other
indices as well. The Nasdaq rallied 3.7% from June 29 through July 3, but the
losses of the past several days have already caused the index to give back
all of that gain:

As you can see, the Nasdaq has also fallen back down into its
prior trading range from the latter half of July. This equates to a

61.8% Fibonacci retracement from its June 13 low up to the July 3 high. When
an index retraces beyond this level, the odds of it significantly reversing back
up are greatly diminished, but it could still happen if the Nasdaq
doesn’t go any lower within the next several days. Any further weakness in the
Nasdaq could result in significant downward momentum that would cause a test of
the June 13 low. Obviously, the other major indices would have a difficult time
bucking the trend if that happens. Remember that the S&P 500 is holding above
its 200-day moving average by only four points.

Open ETF positions:

 

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