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Trader's Corner

When Indexes and Market Sectors Diverge

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Can you please explain the "fundamentally" part in this quote from your most recent recap:

"1560 is next lower support in my estimation; a move to this level would 'fill in' the upside gap from earlier in the month (July) and is a natural support point technically and fundamentally."

[This question related to my weekend Index Trader wrap of 7/30 and which is viewable online by clicking here.]

Well, underlying most, if not all, 'technical' principles, there is a 'fundamental' concept or perhaps its better said that there's an underlying market dynamic. A 'gap' is a price area where there was no buying or selling that occurred. This was due to bids being quite strong on an opening in the case of an upside gap; and, heavy selling on the opening, in the case of a downside gap.

In the example of an upside gap, there is a price point or zone left where would-be buyers would have liked to have purchased, but sellers were not willing to sell in this area and higher prices were required to induce them to sell.

On the way back down, when prices fall into the 'gap' area, there are often or usually willing buyers who would like to buy the index (or stock) at the low end of the gap - where they couldn't before. This is, so to speak, a 'fundamental' reason as opposed to the 'technical' reason simple that the gap is being 'filled in'.

I am stretching the meaning of 'fundamental' here. It's more about the underlying market dynamic related to the 'technical' concept that gaps tend to act as support (or resistance) areas.

You wrote about relationship between different indexes and different markets or commodities like oil. Where a move in one market lik oil might forecast trouble ahead for stocks.

How about discussing why the different indexes are diverging and what if anything we can make of this? The Russell is going up strongly but the OEX is lagging. The broad market is going up, but not the big-cap stocks so much. NDX is lagging the Nas Composite quite a bit.

I did write on the subject of different indexes (or stocks) that may act as a forecaster or 'bellwether' for other indexes; e.g., the small-cap Russell 2000 (RUT)looks like it is going to the moon and is leading the Nasdaq parade; last week's article (Trader's Corner, 7/27) is viewable by clicking here.

A rising trend in oil prices may not spell trouble for stocks, as we've been seeing lately, as crude gets above $60. We know that rising interest rates do spell trouble. There is an 'inverse' relationship between interest rates and stocks; i.e., they tend to move in OPPOSITE directions. If bond yields are going up, over time there is a point reached where this spells trouble for equities.

It's not so easy to always figure relationships between market sectors. Dow had his theory that new highs in the Dow 30 (INDU) without the Dow Transportation average (TRAN) also following suit, spells trouble for INDU and the economy; e.g., this divergent pattern may show that goods are still being produced, but shipments may be lagging in an inventory buildup. Conversely, TRAN going to a new high, without INDU doing the same, is a Dow theory 'divergence' and could suggest that the economy is not as strong as we think.

By the way, the Transport (TRAN) average has had a tremendous move rally from its 2002 weekly closing low (2027). With its Mch weekly close around 3800, the transport average surpassed its 2000 weekly closing top at 3742.

The Dow (Industrials) would have to close above 11723 to make a similar new high. Right now INDU is seriously lagging what TRAN has done. Perhaps something to keep in mind for later to see how this unfolds.

As regards indexes and sector indexes that have options with some liquidity and widely traded, I find that it's best to trade each index independently.

For example, if BOTH the Oil Stock Index (OIX) and the S&P 500 (SPX) are going up strongly, trade each on the basis of what each chart pattern tells you. I don't assume that rising oil prices are going to necessarily spell trouble for the S&P. Of course, the major oil and oil service stocks are huge companies and well represented in the capitalization weighted SPX.

But there is a tendency, especially on days when a sharp rise in oil prices was said to be a 'reason' for a drop in the market, to think that the trends and the relationship between this sector (OIX) and the broader big-cap SPX index might be to go in opposite directions.

There can be a big lagging tendency, which was true in 2003, when OIX (and oil prices) ran up substantially, versus the minimal rise in SPX. On a percentage basis, the run up in OIX in recent months has been substantially greater than the broader market. Rising oil prices: much better for Exxon, not terrible for the market unless it's an energy price 'shock' that puts us in recession. Hey, maybe if oil prices moderate ahead, SPX will get to the top end of ITS uptrend channel.

I mentioned the Russell 2000 Index (RUT) as a sometimes 'bellwether' (predictor) for the broader big-capitalization indices like the S&P 500 (SPX) or the Nasdaq Composite (COMP). Very strong rallies in the RUT can be a harbinger of a rally in the many, versus the few. Where market participants and money mangers start looking (and finding) 'value' in the smaller companies in the Nasdaq Composite for example.

I didn't fully appreciate the strength of the COMP advance, because the more common situation of the big-cap Nasdaq stocks 'leading' the Composite was not the case on this most recent strong advance in tech move. Actually, as it went, strong moves in 1-2, or a few, big 'name' Nasdaq stocks (e.g., AMZN; or, this week, in MSFT) plus rallies in a LARGE number of smaller tech company stocks, has been enough to propel COMP substantially higher, while the narrower all big-cap Nasdaq 100 lags.

In terms of 'bellwether' sectors, you can't beat the leading role of the Semiconductor Index (SOX), as semiconductor chips are so vital in producing such a wide-range of technical products. As SOX goes, so goes tech so to speak.

I didn't make quite make enough of the fact that SOX last week consolidated in a 'bull flag' pattern, that suggested that another strong spurt higher was likely, which would also 'lead' both the Nasdaq Composite and the Nasdaq 100 (NDX) higher this week.

SOX and NDX were also kind of 'leap-froging' over each other. NDX had consolidated in a (bull) flag pattern the week before last and the index had seen upside follow-through last week. Then SOX formed a similar flag pattern last week, suggesting that NDX might have some more strength ahead also.

Looking ahead, both the chip sector (SOX index) and the Nasdaq 100 (NDX) have some upcoming 'tests'. SOX has nearly retraced 2/3rds or 66% of its last major decline (from Jan Sept of '04). If there is a close over 490 in SOX, not reversed the following day, or in subsequent days, it will suggest that this index could eventually challenge 560, its January high of last year. Conversely, if SOX cannot rise above 490, it may spell trouble in the related NDX, the options of which are more broadly traded.

Even more significantly I think, NDX is nearing its December January double top of last year at 1635 and highlighted by the dashed level on the chart above. A close over 1635, not reversed in subsequent days, will suggest upside potential to around 1660.

One index may reverse, or 'break out', first and act as a bellwether for the other; a reason why it's good to look at both. I tend to keep some charts where I see one under the other or have a 'page' of key index charts for daily/weekly comparison.

Good Trading Success!

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