PLUNGE IN RAILROADS THREATENS DOW THEORY UPTREND -- FALLING CHIP STOCKS FORM ANOTHER NEGATIVE DIVERGENCE AS SOX WEAKENS -- NASDAQ COMPOSITE IS UP AGAINST MAJOR RESISTANCE NEAR 2200

TRANSPORTS FAIL TEST OF SEPEMBER PEAK ... On Monday, I wrote a brief update on the Dow Theory which holds that the Dow Industrials and Transports need to both hit new highs to keep the current uptrend intact. Although the Industrials had already done so, I showed the Dow Transports still testing their September high. Unfortunately, the transportation stocks have weakened since then. After dropping on Wednesday and Thursday, the TRAN fell an additional -3.6% today and is slipping back below its 50-day moving average. The failure of the TRAN to hit a new high sets up a short-term negative divergence between it and the INDU, and increases the odds for a short-term puillback. So far, chart damage has been relatively minor. A drop below its October low at 3655 would be more cause for concern. Most of today's selling came from the rails.

Chart 1

UNION PACIFIC LEADS TRANSPORTATION DROP... Union Pacific's loss of -6.3% made it the day's biggest transportation casualty. Today's price drop comes on the second consecutive day of heavy trading, and threatens to break its early October low. That would complete a short-term "double top" formation. Chart 3 shows Burlington Northern Sante Fe having almost as bad a day. Railroads are economically-sensitive stocks that rise and fall with the economy (since their profits are based on the amount of freight that they carry). At the very least, this week's drop in rail stocks (and weakess in transportation stocks) is a short-term warning signal for the rest of the market.

Chart 2

Chart 3

CHIPS ALSO SHOW NEGATIVE DIVERGENCE... I wrote earlier in the week about negative divergences in housing and retail stocks. Arthur Hill issued the same warning on small cap stocks. Another negative divergence is coming from semiconductor stocks. Chart 4 shows the Semiconductor (SOX) Index falling -3.2% today which makes it one of the day's weakest groups. Notice that its latest bounce stopped right at its September peak at 337 before turning lower. That inability to hit a new high sets up a short-term negative divergence with the Nasdaq Composite Index (top of chart). Of more concern is the downturn in the SOX/COMPQ ratio (below chart). Chips have been one of the technology leaders throughout the market's rally. Loss of chip leadership might be enough to cause some profit-taking in that leading sector. That would especially true if the SOX were to break its early October low at 305.

Chart 4

BROADCOM IS BIGGEST SOX LOSER ... Chart 5 shows Broadcom gapping more than 7% lower today in huge volume. A close below its early October low at 28.29 would be even more serious. The stock has also slipped below its 50-day average. Although the SOX Index itself is still testing its 50-day line, 9 of its 18 component stocks have already fallen below that support line. Two of the bigger ones -- Applied Materials and Texas Instruments -- are shown in charts 6 and 7. Their charts suggest an even weaker chip picture. That's another leadership group the market may be losing.

Chart 5

Chart 6

Chart 7

NASDAQ TESTS OVERHEAD RESISTANCE... Chart 8 shows the Nasdaq Composite Index struggling to maintain its recent move above its September high. Two downside reversal days on Wednesday and Friday suggest that some traders are selling into strength. Those two downside reversals also marked the week's heaviest trading. Part of that may be due to short-term negative divergences shown in the daily RSI line (above chart) and daily MACD lines (below chart). Part of the reason may also be seen in the weekly bars in Chart 9 which shows the Nasdaq up against chart resistance at its early 2008 lows near 2200. Here's one reason why that's important. There still seems to be division among Elliott Wavers as to whether the upswing since March is a new bull market or a strong secondary rally in a long-term bear market. One thing is clear. The 2008 bottom near 2200 marked the end of down wave 1. One of the cardinal Elliott Wave rules is that a counter-trend rally should never move beyond wave one. In other words, a decisive move over 2200 would seem to rule out the bear trend theory. In more traditional chart work, a broken support level (at 2200) usually functions as resistance on a subsequent rally. At the very least, the proximity to overhead resistance near 2200 in Chart 9 may explain some of this week's profit-taking. The fact that the weekly RSI line (top of chart) has reached overbought territory at 70 is also some cause for concern. Underlying support resides at the 50-day moving average and the early October low at 2040. But a number of technical factors suggest increased caution at current levels.

Chart 8

Chart 9