Nasdaq Composite Index Showing Larger-Than-Normal Bearish Divergence
Fewer components within the Nasdaq Composite are participating as the index advances to new highs, a possible signal of a larger-than-normal correction. The index is also showing a lack of participation when compared to the prior two-year trend. Above is a two-year daily chart with three simple moving average periods of 50, 100 and 200 days. Below that is the Cumulative Advance Decline Line (ADL) for the index’s constituents. Arrows pinpoint recent times when new price highs were not confirmed by the ADL. Two small divergences occurred in March and July 2013. They produced small corrections in line with the small signal.
Since the beginning of 2014, the ADL has diverged in a larger proportion than price. In addition to diverging, the index broke the 50 and 100 day moving averages, which hasn’t happened since late 2012. A short-term range may be forming. A break above 4,486 would violate the potential range and suggest the trend continues. A break below 4,350 would suggest a short-term price target of 4,210. Given the short-term price action as it pertains to the longer-term trend, the ADL needs to stay above the May low to retain any bullish credibility. If it breaks lower, the warning of a correction will only get stronger as the rally becomes more dependent on large cap stocks. Regarding large caps, of the 2,531 members within the Nasdaq Composite, 128 have a market capitalization greater than $10 billion, so 5 percent of the index is large cap stocks. By comparison, the S&P 500 has 378 large cap members, or 75 percent, which is why the ADL is confirming the new highs for that index.
The recurring theme of extremely low volatility and overbought conditions have remained consistent within the financial markets. As such, we have begun to step up the level of trading and risk (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 feel the markets are exhibiting an unsustainable upward bias and we are confident in our research that the markets will normalize. We are beginning to see divergent behavior between various indices further supporting 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) 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.