A LOT OF NEGATIVE DIVERGENCES ARE STILL PRESENT ON THE CHARTS -- WATCHING THE NASDAQ RS LINE FOR SIGNS OF LEADERSHIP -- A REVIEW OF THE FOUR-YEAR CYCLE

DOW TRANSPORTS AREN'T CONFIRMING INDUSTRIAL STRENGTH... Last Friday I gave a longer-term look at a lot of market indexes to demonstrate that the 2000 high hadn't been all that important to many of them. Some of them had already exceeded that long-term peak while several were still a long ways from their 2000 high. Today I'm taking a short-term view of things to demonstrate that the recent five-year high by the Dow Industrials and the S&P 500 are taking place while large segments of the market are lagging behind. In other words, there are a lot of negative divergences in place. The most glaring divergence is taking place between the Dow Industrials and the Dow Transports, which brings us back to the Dow Theory. According to that theory, a new bull market high by one of the two needs to be confirmed by a similar high in the other. Chart 1 shows the Dow Industrials exceeding their May highs. The Dow Transports, however, are still 500 points (or -10%) off their spring high and are trading below their 200-day moving average. That's a clearcut negative divergence between the two.

Chart 1

Chart 2

IT'S ONLY A LARGE CAP RALLY ... Another negative divergence is taking place between large cap stocks and smaller ones. Chart 3 shows the S&P 500 Large Cap Index exceeding its May peak. Charts 4 and 5, however, show the S&P 400 Mid Cap Index and the S&P 600 Small Cap Index nowhere near their spring highs. In fact, the MID and SML are trading 8% to 10% below their spring highs respectively. And both of those lagging indexes are still trading below their 200-day moving averages. The message there is two-fold. First, it confirms that the recent market rally is being driven by large cap stocks. Secondly, it shows that the rally is somewhat narrow in scope.

Chart 3

Chart 4

Chart 5

NASDAQ/S&P RATIO IS AN IMPORTANT INDICATOR... Perhaps the most glaring divergence of all is the one between the NYSE market and the Nasdaq. Chart 6 shows the Nasdaq Composite Index still trading nearly 150 points (or -6%) below its spring highs. Although it recently climbed back over its 200-day moving average, the COMPQ is pulling back to retest that line again. One of the more important intermarket ratios that I follow is the one between the Nasdaq and the S&P 500. That's because the overall market usually does better when the Nasdaq is leading it higher. That's been the case since early August (see up arrow) although the ratio has slipped a bit this week. I view the Nasdaq/S&P ratio as important for another reason as well. One of the symptoms of an "early contraction" economic phase is when basic materials and energy stocks peak and money flows into consumer staples, financials, and utilities. That appears to have happened. That's also a sign of an aging bull market. An "early expansion" phase (and a market bottom) is usually led by technology (the Nasdaq). In other words, the Nasdaq/S&P ratio helps tell us where we are in the market and economic cycle.

Chart 6

NASDAQ VS. S&P 500 ... The two top lines in Chart 7 show that the Nasdaq (red line) and the S&P 500 (green line) usually trend in the same direction. The blue blue line, however, paints a different picture. It's a ratio of the Nasdaq divided by the S&P 500. More often than not, when the blue line is rising (the Nasdaq rising faster than the S&P), the market is bullish. That was the case from 1990 to 2000. The ratio peaked in 2000 when the Nasdaq crashed (down arrow). Over the ensuing three years, the Nasdaq lost 80% versus 50% for the S&P. The ratio bottomed in late 2002 in time for the Nasdaq to lead the bull market advance (up arrow). Chart 8 examines what's happened since then.

Chart 7

FIRST NEGATIVE DIVERGENCE EMERGES IN 2006... Chart 8 shows the Nasdaq (red line) and S&P 500 (green line) bottoming together in late 2002 and rising together since then. Each new high in one was confirmed by the other (until this year). Notice also that the Nasdaq/S&P ratio bottomed in late 2002 and rose until the beginning of 2004. The ratio moved sideways through 2004 and 2005. The negative divergence between the two markets is shown more clearly in Chart 9. It shows the S&P 500 high unconfirmed by the Nasdaq market which is a negative divergence. The good news is that the Nasdaq/S&P ratio has been rising since August. I'd keep a pretty close eye on the ratio because it may tell us whether the recent Nasdaq leadership is going to last.

Chart 8

Chart 9

ANOTHER LOOK AT THE FOUR-YEAR CYCLE ... My closing comment on Friday provoked a lot of feedback on the four-year cycle, especially my statement that the market had the four-year cycle working in its favor. First of all, a review of its history. Chart 10 shows that a four-year cycle bottom has occurred on schedule since 1982 (green arrows) with one exception (the 1987 bottom was a year late). The cycle extends all the way back to the 1960s. The last two bottoms occurred in October 1998 and October 2002. Most of the cycle bottoms were formed during October (but some have occurred earlier). On Friday, I observed that the market was entering the dangerous month of October and implied that any pullback would probably be cushioned by the four-year cycle (if it's working this year). We also can't rule out the possibility that the August peak in oil prices moved the cycle low ahead by a couple of months. That would mean that the cycle low has already occurred. I've pointed out before, however, that the four-year bottom is usually preceded by a fairly serious market decline which was absent this year. That may be a warning that this is not a normal cycle. That's why I advise basing one's decisions on current chart trends and their technical indicators more than anything else.

Chart 10