Divergence Forming

Since making a rally high on January 26, 2004, the Nasdaq has been failing to keep up with its less volatile brethren, the Dow and the S&P500. Both of those indices have reached new highs. We see numerous explanations for this budding divergence.

First, we note that the Nasdaq had run much further than the Dow or SPX, and might simply be consolidating those gains. This would not be the first time the Nasdaq has gotten ahead of itself, and needed a little sideways action to work off the overbought condition. The low volume gains and next day reversals support this idea.

Secondly, this could be the beginning of a rotation towards higher quality names. The rally off the March 2003 pre-war lows was particularly concentrated in low profit, high beta names. It would be a healthy development to see investors rediscovering profitable dividend payers at this stage of the cycle.

Mutual fund managers – many of whom were under-invested in 2003 – have desperately sought to avoid that fate again. They quickly leapt out of the gate in the beginning of the New Year, and aggressively deployed capital. That source of liquidity looks to be slowing up a bit.

Additionally, the market is entering into a relatively catalyst free period. Earnings reports are ending. Pension fund reallocations are complete, and year-end bonuses and tax planning investments are also mostly finished.

The Nasdaq’s internals remain healthy, but somewhat less so than on the NYSE. Nasdaq advance/declines are positive, but less so than on the NYSE. While the NYSE was making 261 net new highs, the Nasdaq has lagged, seeing only 173 new highs. Volume has also been lighter on the Nasdaq.

Finally, it could just be that the long awaited Nasdaq correction is nearing. Momentum has been waning and volume trailing off, even as volatility continues to decline.

As we have seen in many of the very positive earnings stories on the tech index – DELL, AMAT, CSCO – much of the good news is already baked in to prices. It would be prudent, in our opinion, to tighten stop levels on individual issues – in the event a serious correction occurs.

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