NEGATIVE DIVERGENCES WEIGH ON STOCKS -- NASDAQ COMPOSITE TESTS ITS 200-DAY AVERAGE -- SMALL CAPS CONTINUE TO UNDERPERFORM -- ENERGY SECTOR LEADS WHILE TECHNOLOGY LAGS.
NEGATIVE DIVERGENCES ON SPX... A number of negative divergences have shown up on the major stock indexes which have weakened the market's technical condition. Those divergences are showing up mainly in daily momentum oscillators. Chart 1 shows the S&P 500 rallying to a new record at the end of December and the start of January. The line in the upper box, however, shows its 14-day RSI line failing to do so (see red arrow). The red arrow in the middle box shows the same failure taking place in its daily MACD lines. Those divergences are usually warning signs that the uptrend is weakening. The same negative divergences are showing up in the Dow Industrials. Chart 1 also shows the SPX falling below its 50-day moving average which confirms that the price trend is weakening. Other warning signs are coming from underperformance of the Nasdaq and small cap indexes.
NASDAQ COMPOSITE IS TESTING ITS 200-DAY LINE... The daily bars in Chart 2 show the late December rally in the Nasdaq Composite Index falling well short of its November high. That created a negative divergence between that index and the Dow and S&P 500. And warned of relative weakness in the technology sector which dominates the Nasdaq market. The chart also shows the Nasdaq index in the process of testing its 200-day moving average. The COMPQ hasn't closed below that long term support line since the spring of 2020. It bounced off that red line on Monday but is retesting it again today. That's an important test for it and possibly for the rest of the market. If prices close below the 200-day line, the next potential support level would be at its October low.
SMALL CAP WEAKNESS IS ANOTHER WARNING... Small caps have become one of the weakest parts of the market. Chart 3 shows the Russell 2000 iShares (IWM) trading well below its 200-day moving average. In addition, it's nearing a test of previous support formed over the last year (see red line). That's an important test that also bears watching. Relative weakness in smaller stocks is usually a sign that market breadth is deteriorating.
ENERGY LEADS WHILE TECHNOLOGY LAGS... Chart 4 compares the eleven sectors in the S&P 500 over the last month. And it shows energy and financials in a leadership role; with technology in last place. My previous message explained that energy and financials are linked in the sense that both are benefiting from rising inflation and impending rate increases by the Fed to combat that inflation. Energy shares are benefiting from rising energy prices; while financials have been helped by rising bond yields. Rising yields, however, are also putting downside pressure on technology stocks.
COMPARISON OF BOND YIELDS AND XLK... Technology shares are sensitive to the direction of bond yields. They usually do better when yields are dropping and worse when yields are rising. Chart 1 compares the 10-Year Treasury yield (green line) to a ratio of the Technology SPDR (XLK) to the S&P 500 (black line) over the last year. And it shows them generally moving in opposite directions. The rising XLK:SPX ratio last spring shows Technology shares starting to outperform at the same time that bond yields were starting to drop (see arrows). Rising bond yields starting last August caused the XLK:SPX ratio to flatten. The upside spike in bond yields starting in December coincided with a drop in technology relative performance. That helps explain why the Nasdaq has been underperforming the Dow and S&P 500. The big question is what happens from here. Bond yields are expected to climb this year as part of Fed tightening. That could act as a drag on the tech-dominated Nasdaq market, and may have a negative impact on the rest of the market.
