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Behind the Scenes, Is NASDAQ Deteriorating?

By Chris Rowe June 27, 2007 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

Most investors spend way too much time and energy trying to make a call on whether or not "the market" is at an appropriate level, or what the appropriate level is.  How do these people think that they can value the market anyway?

It's difficult enough for some people to figure out what direction the market is actually in, and which sections of the market are strong and which sections are weak. 

But then trying to VALUE the weighted average on top of everything?  That means that you are not only trying to value one single stock, but you are trying to estimate the total value of each stock in a particular index, and then average the value of those stocks properly by assigning their proper weight in the index.  (Different stocks hold a different amount of weight on each index.)  And it's not even the current values that you have to be right about.  It's future values!

And when it comes down to it, in hindsight, your perception of the future market's value two years ago is not what you still believe it to be today.

And even if you maintained your opinion on where you thought the market should be over the past two years, that likely has nothing to do with what the market will have actually done.  Your opinion of where it should be may be dead on, but that doesn't mean that the rest of the world has to fairly and accurately value the market.

What's the point?

Before attempting to accomplish a feat that no man has ever accomplished consistently for any long period of time (calling the market's future), you might want to try mastering the ability to tell which way the market is really moving right now, and which parts of the market are strong, weak, undervalued or overvalued.

Mastering the market internals is a great place to start.  The market internals are also known as the "breadth" of the market.

The internals reveal what's truly going on with the market, and can usually help to give you a peek into the market's future.

Here's how we know that the NYSE is currently much stronger than NASDAQ.

In the chart below, focus on the A/D (advance / decline line) which is overlapping the NASDAQ.  (Skip the RSI in the bottom portion for now.) 

The A/D line is the one that's above the NASDAQ on the left side and below the NASDAQ on the right side with blue arrows pointing to it.  I say this only to identify the A/D line.  (The direction of the line relative to the NASDAQ is what's important, not the level it's at.)

NASDAQ vs. A/D line (overlap,) 2-year daily chart

The A/D line shows the cumulative difference of the number of advancing issues vs. declining issues.  When the A/D line moves in the opposite direction of an index, the index usually ends up following the direction of the A/D line.  This is called a "divergence," which I've discussed in recent articles like "NYSE Bears at 76-year High" and "What To Do When You're Bullish/Neutral." 

You can see that the new highs made by the NASDAQ on the right side are not being confirmed by an increasing number of advancing stocks. 

Near the first two blue arrows, you can see that the A/D line was making lower highs while the NASDAQ made higher highs.  That was followed by the February correction.  You can see near the last blue arrow that this time there's an even larger divergence!

NOW look at the RSI at the bottom portion of the chart.  Even the RSI (which is a momentum indicator) shows a negative divergence.  You can see what followed the first two negative divergences (red lines.)  I thought it would be helpful to also show the positive divergence in the RSI in mid-2006 (green line) which was an RSI buy sign.

Getting back to the A/D line ...

It always helps, when looking at charts, to look at a longer-term perspective.  So let's zoom out for a second to study the next chart which dates back to mid-2002.  You can see the difference between the direction of the market and the direction of the A/D line (each marked by the blue arrows) starting in mid-2006. 

You can see that negative divergence in the A/D line, again, that preceded the February correction, and you can see the same sort of thing happening right now! 

NASDAQ vs. A/D line (overlap,) 5-year daily chart

Again, I thought I'd mark the negative divergences in the RSI.  (Read more about the RSI in my article "How to Sell At The Right Time")

Maybe it will help to view the same exact chart as above without all of my annoying chicken scratch mixed in.  Here:

NASDAQ vs. A/D line (overlap,) 5-year daily chart

What was I talking about again?  ... Oh Yes!  It seems that we've come full circle.  The NASDAQ being much weaker than the NYSE.

The NYSE A/D line is pretty much in line with the NYSE Composite.  You can see this below, or maybe you didn't notice it because the two lines are practically overlapping.  But then I still highlighted two negative divergences in the RSI and left another huge one unmarked (which was followed by a correction - hint hint) to give you an activity.

NYSE Composite vs. A/D line (overlap,) 2-year daily chart

Now I'll tell you one last thing, and then I have to go to sleep (It's 2:00 am Wednesday as I write this...).

The NASDAQ tends to lead the NYSE.

That's right.  When the NYSE is rising and the NASDAQ is falling, that, in itself, is a negative divergence.  It also shows that people are less willing to put their money in the smaller companies.  (Of course MSFT and INTC are listed on the NASDAQ, but on aggregate, smaller, younger companies are on the NASDAQ, and INTC and MSFT only count for two votes as we are talking "internals" here anyway.)

Of course, I did write about a seasonal 12-day sweet spot that the NASDAQ tends to experience at this time in last Thursday's article.  But you have to consider all of the indicators in conjunction with the seasonality factor.

The long-term uptrend is still intact, but it's looking SHAKY right here.  BE CAREFUL!  If you haven't reduced your risk in one way or another, now is a great time to do so.  I'm not a bull or a bear right now.  I'm playing both sides of the market.  But if you're going to be long, be long the NYSE stocks.  But it doesn't hurt to reduce the exposure in anything that you're long.

Feedback is welcomed! (See below.)