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Reality Check

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Sometimes, I don't know what I'd do for article ideas if it weren't for all the great questions I get from readers. That's certainly the case today, as one of my regular readers reminded me of some comments I made around the start of the year, wondering if they're still valid. When I was in my predictive mode (with the rest of the Financial community) around the first of the year, I talked about my expectations for 2003 and whether we would get an unprecedented fourth down year, or if the markets would somehow stumble their way to a positive close this year. As is so often the case, I bit off more than I could chew with that topic, and the discussion took two articles to cover. If you missed the articles the first time around, I'd suggest taking a look here.

'Tis The Season

'Tis The Season, Part II

Since writing those articles, Buzz Lynn has done a great job of handling the many big-picture items that I didn't get to, saving me that Herculean effort. Some of my near-term views have been proven correct and others, well, not-so-correct. GRIN Fortunately, today's question deals with an aspect of my prognostication that I think is still very much in force. So without further delay, let's get to it!

My question this time is with regard to the amazing resilience I see in the QQQ's. I recall you mentioning sometime ago in one of your Sunday writings that you don't expect much weakness in the NASDAQ stocks. This is what I now see. The only breakdown (if we can call it that) in the QQQ's occurred on February 13th when they went down to 23.25. Since then I have not seen the Q's below the 24 level.

Do you think this is genuinely bullish scenario or we could see the Q's suddenly giving way and overtaking even the SPX to the downside? I am puzzled as to what to make of this. NASDAQ stocks with no earnings outperforming the Dow and the S&P.

Now see, that's a great observation. The NASDAQ IS holding up better than the rest of the market lately. I don't know that I'd exactly call it strong, but it is exhibiting strength relative to the broader market. This is the kind of behavior I expected when I wrote those articles back in January, and I've got a couple primary reasons for that view.

First off, Technology stocks fueled the irrational mania that took the NASDAQ to its peak in early 2000, and while the rest of the market certainly went along for the ride, the extreme over-valuations were primarily concentrated in the Technology arena. So it only makes sense that the bulk of the ensuing carnage in the market was focused in the Technology space as well. At its depth last October, the NASDAQ Composite had shed 78% of its peak value from March of 2000. By that time the COMPX had fallen back to levels not seen since July of 1996!

By contrast, at the October lows, the SPX had "only" given back 50% of its peak value from early 2000 and still had more than 130 points to go before challenging its own July 1996 levels. By my way of thinking, that meant the broader market had more potential downside in store than did the Technology sector.

The other factor influencing my bias of greater downside potential away from Technology was the weekly chart patterns of the COMPX and the SPX. The SPX has been mired in a persistent descending channel since topping out in 2000, and has been methodically working its way lower in that channel. By contrast, the COMPX got the bulk of its decline out of the way by early 2001 and since then has been declining at a much more pedestrian rate than the SPX. An argument can be made for a descending channel in the COMPX as well, but note how much shallower it is than that seen on the SPX.

Weekly Chart of the SPX

Weekly Chart of the COMPX

We could look at the daily chart of either the COMPX or the SPX and draw an ascending trendline from the October lows to the February 13th low and in both cases, we can see that price action is holding above those trendlines. But I think a more useful way to view the difference between the strength in these two indices is through the application of one of my favorite tools, the relative strength chart. Below, I have shown a chart of the COMPX relative to the SPX, and the relative strength jumps out at us, don't you think?

Relative Strength Chart of the COMPX vs. the SPX - Weekly

Note how this chart bottomed just above 1.40 (don't try to figure out the scale) in late 2001 and that defined a floor again last October. And while both indices would be classified as weak right now, the upward trend since December indicates less selling pressure in the COMPX than the SPX. This developing trend is even more apparent if we look at a daily chart.

Relative Strength Chart of the COMPX vs. the SPX - Daily

I think this series of charts goes a long ways toward explaining why the QQQ has been rather resistant to selling off, even in the midst of what is clearly weakness in the rest of the market. Watch the center lines on the channels shown on those weekly charts, as that will be the key for further downside from here. I think it is highly unlikely that the COMPX will break down into the lower half of its channel without the SPX leading the way with a break below its channel center line. I wouldn't say that the QQQ makes for a great bullish trade, but I would suggest that bears would do well to look for a better target for playing the downside in the current environment. Here's a concrete measurement we can use in the future to gauge whether the NASDAQ is continuing with this relative outperformance. Watch the top of those channels for a breakout to the upside. I'm betting that the bulls will be able to crest the top of the COMPX channel before they can clear the top of the SPX channel. Time will tell!

What it really comes down to is an issue of financial performance RELATIVE TO expectations. In my opinion, expectations in the Technology arena were taken so low over the past couple years, that successive disappointments aren't having the pronounced effect they did in the recent past. On the other hand, expectations for financial performance outside of the technology market have come down at a more controlled rate, leaving further room to the downside as this bear market continues and expectations continue to be reduced.

The possibility still exists for another significant leg down in the broad market, and when that materializes, it is highly likely that the NASDAQ market will be pressured below recent support. One thing I do not expect is for the COMPX to suddenly plunge and play catch up with the rest of the market. I think the days of the NASDAQ leading to the downside are behind us. If I'm correct, the better bearish play will clearly be found in areas of the market that are not exhibiting this relative strength. Any ideas what those might be? Take a look at some relative strength charts over the weekend and send your ideas along. Please put "Relative Weakness" in the subject line. We'll take a look at some of your ideas next week.

Questions are always welcome!

Mark



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