NASDAQ PULLBACK WEIGHS ON MARKET -- THE SEMICONDUCTOR (SOX) AND OIL SERVICE (OSX) INDEXES ARE TESTING 2005 HIGH -- WHICHEVER BREAKS OUT FIRST COULD DETERMINE MARKET DIRECTION

NASDAQ 100 HOLDING THE MARKET BACK ... Ever since the Nasdaq market backed off from its spring high a couple of weeks ago, the rest of the market rally has stalled. That's because the market needs Nasdaq leadership to continue its summer rally. Last week I showed the Nasdaq Composite rally stopping at its spring high near 2100. Chart 1 shows the Nasdaq 100 Shares (QQQQ) pulling back from their February peak near 38.5 (see circle). It's unlikely that a market rally can resume as long as the QQQQ is falling. So it bears close watching. So far its pullback has been on relatively light volume which is positive. Chart 1 shows three reasons why there's important chart support near 37. One is because that's the early April peak (first arrow). A second reason is because 37 also represents a 38% retracement of the May rally. A third is that the 200-day moving average sits near 37 (red arrow). There's another reason which is shown in Chart 2.

Chart 1

MORE SUPPORT AT 37 ... Chart 2 plots Bollinger Bands around the QQQQ. Since the price has closed below the dashed 20-day moving average, there's a likelihood that it will reach the lower band which sits near 37. A falling upper band is causing the bands to narrow. That can be seen in the Bollinger Band Width beneath the price chart. That's normally associated with a market pullback as well. Until the band width starts to widen, the QQQQ may continue to correct or consolidate. Part of the reason for QQQQ weakness is selling in the semiconductor group.

Chart 2

Chart 3

SEMICONDUCTORS PULLING NASDAQ LOWER ... During my afternoon interview on CNBC today, I tried to make the point (which I've made here before) that the semiconductor group might hold the key to Nasdaq direction and, by implication, the rest of the market. Last week I showed the Semiconductor Holders (SMH) failing a test of their March highs. Since then, they've slipped beneath their 20-day average as well. That calls for a further dip to the lower Bollinger band. The relative strength ratio beneath the chart shows the SMH versus the QQQQ. It shows that the SMH helped lead the QQQQ higher from mid-April. The recent pullback in the ratio from its early March peak is one of the reasons that the QQQQ is slipping. And that helps explain why the rally in the broader market has stalled.

OIL SERVICE HOLDERS CHALLENGE RECORD HIGHS ... This is the second chart I showed on CNBC today to demonstrate that the Oil Service Holders (OIH) are testing their 2005 high. Its relative strength ratio (versus the S&P 500) is also testing its 2005 high. I can't say whether or not the OIH will break through on this attempt. It is in overbought territory and looks a little extended. But I believe it will get through that barrier eventually. Chart 5 shows why that's such a major test. I showed it last week, but here it is again. It shows that the Oil Service Index (OSX) is challenging its previous peaks formed in 2000 and late 1997 (see circles). There are two ways to view Chart 5. One is that the presence of overhead resistance is a cautionary sign that calls for corrective action. That was one of the reasons that I called for some profit-taking in the energy group earlier in the year. This is the second attempt at a record high however. Each successive attempt increases the odds for an eventual breakout. I don't know if it will get through this time, but I believe that it will do so eventually.

Chart 4

Chart 5

WATCH THE OSX AND THE SOX... The gist of my interview on TV today was to keep on eye on these two key indexes. Both are testing overhead resistance. Whichever one breaks out first could determine overall market direction. If the Semiconductor Holders (SMH) reach a new 2005 peak, that would give a boost to the Nasdaq and the rest of the market. If you're a bull on the market, root for the Semiconductor (SOX) Index. If the Oil Service (OSX) Index reaches a record high, that will be good for the energy sector but not for the rest of the market.