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Sunday, July 24, 2011

A Tale of Two Tops

Friday, the NASDAQ 100 (NDX) made a new high at 2433, a level not seen since Feb 2001.  It got a lot of folks wondering whether SPX has another high on the way.  It doesn't, and here's why.

In 2001, when NDX peaked at 4816, it was a runaway.  It had grown tenfold in less than 6 years (SPX grew 1.3 X during the same period.)  When NDX crashed, it fell 84%.  So, when it rebounded in 2007, is it any wonder that it only retraced 36% of the decline (versus 100% for SPX)?

A glance at the chart below tells the 2007 story.  NDX followed the same general pattern as SPX, but failed to spike as much in July.  Only in October did reluctant investors finally forget the past, bidding it up at a much faster clip than SPX.  Between its July and October peaks, for instance, SPX gained 20 points (1.2%).  In the same period, NDX gained 179 points (8.6%).



When SPX reached its all-time high on October 11, it was tired.  Twenty points in 3 months is a lot of effort for little reward.  But NDX, playing catch up, still had plenty of momentum -- gaining another 108 points before finally peaking two weeks later on October 31 after making three higher highs in a row.

Many investors no doubt wondered, as NDX hit 2239 on Oct 31, whether SPX would join it in making a higher high.  It was only 27 points away from completing a massive Inverse Head & Shoulders pattern that might have sent it up 190 points.  Instead, SPX made its first lower high at 1553 (spitting distance from its first topping pattern high of 1556 on 7/19).  It would go on to make successive lower highs, eventually completing a traditional H&S pattern and tumbling 58%.

In retrospect, NDX's peak -- coming two weeks after SPX's -- was a great indicator of bearish capitulation.   Understandably reluctant investors, by finally turning euphoric, marked the top in a way that would make Prechter proud.  The divergence between NDX's higher high and SPX's lower high was a great warning sign.

*****

Let's turn our attention to 2011.  NDX made three higher highs in a row on Feb 18, May 2 and Jul 7.  On those same days, SPX made what might be a head and two shoulders.  NDX's last higher high on July 7 was the same date on which SPX made its first lower high (the right shoulder).  Divergence.



On Friday, 2 weeks later, NDX beat that Jul 7 peak by 14 points.  SPX came in 10 points lower than its Jul 7 peak.  More divergence.

And, let's not forget that NDX has retraced 116% of its 2007-2009 losses.  For SPX, it's only 77%.  Some would consider that divergence.

Still, we're left to wonder whether SPX might tag along.  After all, it's just 10 points away from completing a sizable IHS that could send it up 90 points.  It's not hard to imagine in this Apple-infused euphoria that's enabled investors to ignore the greatest economic calamity to face the world in 80 years.


It's entirely possible that 2011 won't pull a page from the 2007 playbook, that QE will enable only increasing valuations,  that the debt ceiling increase will magically result in a better economic backdrop for profits -- that this time is different.

Don't bet on it.

3 comments:

  1. Interesting insights! We are going into a serious phase of deleveraging in the U.S. and I'm trying to understand how this is going to be good for the markets?
    Over $11 trillion dollars has been erased from U.S. housing values and only getting worse. If the Fed "printed" 2.4 trillion dollars in the last few years, then the Dollar should be worth more. There are $9 trillion less dollars in the system just in housing. It will be interesting how much bad debt will default in the next few years. All if this has to be Dollar positive, yet the Dollar bears don't see this.

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  2. Good point ...and the real estate losses haven't, for the most part, been booked by the banks or families affected. Absent a miracle recovery, those have to come home to roost eventually. I think the dollar is in for some huge swings, but at the end of the day, which currency is more attractive? Where could you relocate the 60% of reserves that USD represents? I think we'll finally see the decoupling of USD and stocks that I've been harping about, at least after the initial shock.

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  3. Well-written. Easy to follow.

    ReplyDelete