The concept of an Index bellwether is a big name stock that tends to LEAD the Index by showing strength or weakness ahead of the Index it's part of. The S&P and Nasdaq 'bellwethers' have changed over the past 12-15 months.

Whereas GE used to be an effective bellwether for the S&P 500 (SPX) and 100 (OEX) indices, IBM has taken over that role; IBM in fact used to be the preeminent Dow and SPX bellwether back in the 70's and into the 80's (until 1987).

I define bellwethers in my (Essential Technical Analysis) book as: "A stock, related index, or sub-index that tends to move in the same direction at the same time, or to move in advance of, a broad average or index. When a bellwether fails to at least move in the same direction as the broad index and/or for example, to also go to a new relative high or low, this (pattern) sets up a divergence and a warning of a possible trend reversal."

BELLWETHER STOCKS OR SECTORS

The concept of the bellwether stock or sub-index is that there are certain companies, market sectors (e.g., semiconductor stocks) or indexes that by virtue of their size or relative importance will be virtual 'stand-ins' for, or will be closely linked to, a market index or average. The most famous and earliest example of a bellwether is the role the Dow Transportation Average (TRAN) plays as a linked average to the Dow Industrials. If one average or the other fails to also move to a new high or low, this is a bullish or bearish divergence. For example, INDU goes to a new high well above 13000, but TRAN trades well below its prior high. This is a bearish divergence with eventual bearish implications for the Industrials unless the Transports catch up.

As a bellwether goes, 'so goes the market', is key to the role of the bellwether. In the mega-bull market of the late-1990's, Cisco Systems (CSCO) was 'the' stock to follow if you wanted to gauge the prospects and strength/weakness of the Nasdaq Indices. Cisco, along with Nasdaq biggies, Microsoft Inc. (MSFT) and Intel Corp. (INTC), accounted for close to 25% of the entire value of the Index during this period.

SIZE alone is not the only criteria for assuming a bellwether status. As important, it must be a company that has had stellar growth and represents the leading edge business that exemplifies that exchange. In the case of Nasdaq, the internet and communications revolution was driving this exchange (beside the rapid high-tech growth in general) and Cisco was perceived as the leading company in supplying the required equipment to run it.

The Semiconductor Index (SOX), as calculated by the Philadelphia Options Exchange, in an index of stocks that provide a key underlying component of the high technology industry. Without the participation of the stocks making up the semiconductor index, the overall Nasdaq market will not be firing on all cylinders in terms of a strong trend.

If both the index and its bellwether are going up and a top forms in the index but not in the bellwether, it suggests being cautious about bearish plays in the index; the apparent index top may be short-lived.

If both the index and its bellwether are declining, but a bottom sets up in the bellwether ahead of the index, this pattern is an alert for a similar upside reversal to set up in the index.

BELLWETHER STOCKS PAST AND PRESENT FOR THE S&P AND NASDAQ

GE was for a long time a key bellwether component of the Dow and because it was such a big company, especially so in the capitalization weighted S&P. You can see that changing story in my first chart of the S&P 500 and GE in the lower portion.

When SPX made a closing high at 1363 in late-April last year, GE made a LOWER high in the same time period per my chart highlights. This was the perfect role of the bellwether; by this divergence, GE was suggesting that a top was forming in SPX also. It just took a while as befits an index of so many stocks, not just one.

Later in 2011, GE stopped being an effective bellwether of the S&P as it took longer to form a bottom and since then has significantly lagged the index. GE is far from a new high, whereas SPX just made one. The stock that gets the new honors as a key S&P bellwether is IBM, a premier past bellwether.

The charts of SPX and IBM for the period shown below highlight two divergent patterns. SPX formed a top, IBM did NOT. IBM fell with the S&P but make its closing low in mid-August, versus some weeks later in the Index. Not only were these comparisons showing the greater relative strength of IBM (a great buy and hold), but they were suggesting the strength that was to come later in the S&P.

The SPX top was still a very tradable one but once the downside objective implied by the rectangle top; see the 'measuring' implications implied by such a top in my 4/11/11 Trader's Corner article.

In the case of the Nasdaq, I mentioned earlier that Cisco Systems used to be a premier bellwether for the Nasdaq Composite and Nasdaq 100 (NDX). My comparative chart below suggests that CSCO has significantly diverged from NDX in its decline over the months into its final bottom last July. However, until early-July NDX was in a strong uptrend. The prolonged bearish decline in CSCO was relevant to what was happening with the company, not the broader Nasdaq market.

The new champion bellwether for NDX is Apple Computer (AAPL). When NDX declined sharply from late-July into mid-August 2011, AAPL was mostly tracking higher during that same period. Action in AAPL could have gotten you prepared (if you weren't already!) for the turnaround in the Nas 100. If you only bought QQQ, you were a winner, let along buying NDX calls.


GOOD TRADING SUCCESS!