Nasdaq Composite Index Showing Larger-Than-Normal Bearish Divergence
This is an update to a blog posted 3 weeks ago. As we saw at the previous high made in the Nasdaq Composite, the new high made yesterday was not confirmed by the market breadth reading (# of advancing stocks minus # of declining stocks on each day). The chart above shows the Nasdaq reaching new highs while the Cumulative Advance/Decline Line (ADL) in the bottom right lower half of the chart failed to follow through. Even more pronounced though is how much the ADL missed new highs as the blue arrow shows the slope of the change from the prior index high. This is a strong bearish divergence that has caught our attention.
With only 128 of 2531 members of the Nasdaq Composite considered large-cap (or 5% of the index) versus 75% of the S&P 500 considered large-cap and considering the S&P is confirming its new index highs with new highs in its ADL, the divergence between Nasdaq and S&P indices can be attributed to the small-cap stocks significantly underperforming the large-caps. As the rally becomes more dependent on large-cap stocks, any threat of a correction will be much stronger if there is any significant break in the market’s momentum. We feel that the market is stretched and is showing signs that a meaningful corrective move is coming.
Our research is pointing to a late third quarter or early fourth quarter correction of -13% to -20%. The recurring theme of extremely low volatility and overbought conditions has remained consistent within the financial markets. As such, we have been more aggressive with the level of trading and risk taking (position size) proportionate to our confidence that our trading models will respond properly. We are currently net short with several positions and are monitoring them day and night. We think the markets are exhibiting an unsustainable upward bias and we are confident in our research that the markets will normalize. We are seeing divergent behavior between various indices that further supports our research and strategy. With the markets fluctuating hourly, we have been trading around the core net short position and repositioning for a reversal that is long overdue.
Over the last month we initiated (in stages) and traded around a hedge on the S&P, Nasdaq and Dow indices which gives us a 25% protective hedge on the portfolios. Along with the hedge, we will carry cash weightings in the portfolios between 10% and 15%.
When the market correction runs its course and/or the markets tell us that they want to move higher based on our research, we will remove the hedge and begin the process of getting back into the markets and get fully invested. Until then we remain diligent in our research and will continually monitor the markets and report back at the quarter end.