MARKET PULLS BACK FROM OVERBOUGHT CONDITION -- SMALL CAPS AND NASDAQ ARE STILL BELOW 200-DAY LINE -- DOW TRANSPORTS REMAIN WEAK -- WATCH OUT FOR HEAVIER DOWNSIDE VOLUME IN SEPTEMBER

SMALL CAPS CONTINUE TO LAG ... Last Friday I showed the Nasdaq Composite entering a resistance zone marked by its early July peak at 2190 and its 200-day moving average. I wrote that what the Nasdaq did in that zone would tell us a lot about its real strength and that of the entire market. Although it's too soon to draw any major conclusions, Chart 1 shows the Nasdaq backing off from that resistance zone. That's contributing to a general market pullback. Small and midsize stocks are also backing off from resistance around their 200-day moving averages. Charts 2 and 3 show the S&P 600 Small Cap Index and the S&P 400 Mid Cap Index backing off from their 200-day lines. Smaller stocks have lagged behind large caps during the recent market rally which I believe is a sign of a more defensive market. The inability to continue their market bounce may also be contributing to today's pullback. There are other groups that are having similar problem with their 200-day averages.

Chart 1

Chart 2

Chart 3

MORE INDEXES BACKING OFF FROM 200-DAY LINES ... There are several other market indexes that are having trouble climbing back above their 200-day averages. Three of them are shown below. The Internet Index (Chart 4) looks very similar to the Nasdaq chart . The IIX is backing off from its summer peak and its 200-day average. Chart 5 shows the Biotech Index, which has been an underachiever during the recent rally, backing off from its summer highs and its 200-day line. Selling in retail stocks was very pronounced today. Chart 6 shows the Retail Holders (RTH) failing a test of its 200-day line. The fact that so many market groups are still trading below that resistance line helps demonstrate how narrow the recent market rally has been. Their weakness no doubt contributed to today's selling. That and an overbought condition.

Chart 4

Chart 5

Chart 6

ANOTHER LOOK AT DOW THEORY... Chart 7 shows the Dow Industrials pulling back from an overbought condition, which is shown by the 9-day RSI line having moved over 70 for the first time since early May (when the market peaked). The daily MACD lines (below the chart) are still positive, but just barely. They too are in an overbought condition near their May high. Last Friday I mentioned the Dow Theory which holds that for a bull trend to continue, the Dow Industrials and the Transports should be rising together. That clearly hasn't been the case recently. While the Dow Industrials reached a new three and half month high, the Dow Transports (Chart 8) recently fell to a new 2006 low and remain well below their 200-day average. If anything, the recent consolidation pattern in the transports looks more like a "coil" or "symmetrical triangle" which is usually resolved to the downside. Weakness in the transports is usually a sign of economic weakness. And their inability to confirm the recent rally in the Dow Industrials makes even that rally suspect.

Chart 7

Chart 8

WATCH OUT FOR SEPTEMBER ... It's a well known market maxim that September is usually the weakest month of the year for the market. That raises the risk level for the market at a time that it's in an overbought condition. That plus the fact that the Nasdaq and small cap indexes may be failing at their 200-day averages. It's important to keep a close eye on volume over the next week. The August rally took place on very low volume. That's not unusual for the month of August, but detracted from the price gains. Volume usually picks up in September as traders get back to their trading desks. That won't be a good sign if the volume starts to pick up as prices start to drop. That's what happened today. Chart 9 shows the NYSE Composite Index falling today on the heavest trading since mid-August. That suggests that returning traders are in a selling mood. Technical and seasonal patterns suggest a more cautious stance at this point in the market cycle as it enters the dangerous September/October time period.

Chart 9