ROTATIONS CONTINUE OUT OF CYCLICALS AND SMALL CAPS -- DRUG/SOX RATIO TURNS UP WHICH SHOWS CAUTIOUS MOOD -- LOSS OF NASDAQ LEADERSHIP COULD BE BAD FOR MARKET

OUT OF CYCLICALS AND INTO CONSUMER STAPLES... One of the best visual ways to spot group rotations is with ratio or relative strength analysis. There are two ways to do that. One is to compare each index to the S&P 500 and to see which ones are outperforming and which ones are underperforming. An even easier way is to do a relative strength ratio of the two groups themselves. That's the approach we're using here to show visually some of the sector rotations that are going on in the market place. Last week I talked about how the threat of rising interest rates was causing a rotation out of economically-sensitive cyclical stocks into the more defensive consumer staples. That relationship can be seen in Chart 1 which plots a ratio of the Morgan Stanley Cyclical and Consumer indexes. The ratio has fallen under its 50-day average for the first time since last April. That represents a change in trend away from cyclicals and toward consumer stocks. Their changing fortunes can be seen on their individual charts. Chart 2 shows the Consumer Index hitting a new 52-week high today, while the Cyclical Index has fallen back to its 50-day average. Notice that the slide in cyclicals started last Wednesday (see red circle) after the last Fed meeting hinted at higher interest rates.

Chart 1

Chart 2

Chart 3

LEAVING SMALL CAPS... Chart 4 plots a ratio of the Russell 2000 Small Cap Index divided by the Russell 1000 Large Cap Index. For the last year, small caps have been in the lead as reflected in a rising ratio line. As the chart shows, however, the small cap/large cap ratio has broken a five-month up trendline. This is the biggest drop in the ratio in a year. That shows a change in leadership away from small caps, which is another sign of a more cautious stock market. Since there are more small stocks than large ones, the loss of leadership by small caps usually results in deterioration in market breadth figures. The monthly bars in Chart 5 also show that the Russell 2000 had reached a potential resistance barrier near 600 at its early 2000 peak and had reached an overbought RSI reading of 70. That's a logical spot for some profit-taking to appear.

Chart 4

Chart 5

OUT OF CHIPS AND INTO DRUGS... I've been writing lately about the relative strength in drugs and the weakness in chip stocks. The next two charts show the DRG Index hitting a new recovery high, while the Semiconductor (SOX) Index has fallen even further under its 50-day line. The DRG/SOX ratio in Chart 8 shows their leadership role reversal in more convincing form. The ratio hit a "double bottom" during November and January. It has broken out over its December high and is now trending higher. That's a classic trend reversal pattern. It means that drugs are now doing better than chips for the first time in more than a year. I often use this particular ratio to assess the mood of the market. Right now, that mood has turned defensive. That hurts the chips, but favors the drugs.

Chart 6

Chart 7

Chart 8

LONGER RANGE LOOK AT DRUGS VS. SOX RATIO... Chart 9 plots the DRG/SOX ratio since 1996. Notice how changes in the ratio correspond with mood changes in the market. A falling ratio from 1998 to early 2000 (first green arrow) shows an optimistic mood as the techs ruled the market. The bottom in the ratio at the start of 2000 (red arrow) showed a more cautious market as drugs rose while the chips fell. The peak in the ratio near the end of 2002 (second green arrow) showed a swing back to tech stocks as the market bottomed. The latest upturn in the ratio (last red arrow) suggests another change in mood back to more caution. The RSI oscillator has also been helpful in pinpointing turns in the ratio line. The peaks in 1998 and late 2002 coindicided with overbought RSI readings. The bottoms in 2000 and late 2003 coincide with oversold RSI readings.

Chart 9

NASDAQ FALLS TO 50-DAY LINE... As has been the case for the past month, the Nasdaq was the worst performing of the major stock averages. Today's drop of -2.5% compares with -.84% for the S&P 500 and -.33% for the Dow. [The small cap Russell 2000 dropped -2.6%]. The daily chart shows the Nasdaq testing two important support levels. One is the 50-day average at 2017. The other is the November/December peaks in the 1992-2000 area. Normally, short-term pullbacks find support along the tops of prior trading ranges. If that zone doesn't hold, the next downside target would be to the December low at 1887. That would be the first double-digit correction (-12%) since this bull market started.

Chart 10

NASDAQ/S&P RATIO MAY BE PEAKING... We'll end up where we started -- with a couple of ratio charts. The Nasdaq/S&P 500 ratio has been dropping for the last month. It's now threatening to break the low formed during December. If it doesn't hold, that will represent the first downside trend reversal in the ratio since last March. Loss of technology leadership is normally a bad sign for market. Chart 12 shows why. The upturn in the ratio in October 2002 correctly identified a major market bottom. (see green arrow). The ratio has been rising ever since thanks to technology leadership. The red arrow to the upper right shows a potential ratio reversal in the making. Chart 12 also shows the ratio testing an up trendline extending back sixteen months. If a rising Nasdaq/S&P 500 ratio has been good for stocks, a falling ratio could be bad.

Chart 11

Chart 12