The major indices have established testing zones that will determine the ultimate fate of the bounce off the Bear Stearns
(BSC)
low. Although prices have pulled back sharply in the last few days, the battle between bulls and bears at these clearly defined inflection points might still go on into mid-June.
The Nasdaq 100 is the outlier there, with lingering strength in a handful of tech giants providing support and lifting the index above its 200-day moving average. But its superior performance has a downside, because it has triggered a plethora of bearish divergences when compared with the S&P 500, Russell 2000 and other indices.
Obviously, there's another complication in reading the position of the major averages and prognosticating direction into the summer months. Crude oil is surging higher in a historic blowoff and giving an unnatural lift to energy stocks. This phenomenon is distorting market numbers, as it has for several years now.
A few bulls still argue that rising crude oil will help, rather than hurt, prospects for a recovery in the major indices. But common sense dictates the opposite conclusion. Besides the obvious drag on consumer spending, the financial markets hate uncertainty. In this context, the jaw-dropping rise in energy prices must be interpreted as highly negative.
The Big-Cap Tech Effect
Let's also consider the surge in big tech compared with price action in other market groups. Back in the 1990s, narrowing leadership showed its face when the Dow Industrials moved higher, while the S&P 500 and Nasdaq Composite lagged far behind. The correlation was considered to be bearish, because the Dow marked the last safe haven before investors pulled in their reins and let the markets fall from its own weight.
The Nasdaq 100 has taken over that safety net as we head into the end of the post-millennium decade, with its household names providing the same sense of security offered by Coca-Cola
(KO)
, General Motors
(GM)
and other Dow components in prior years. But the dynamics remain the same, i.e., thin leadership is a precursor of lower prices.
As I watched the market test the rally highs on Monday, before mid-afternoon program selling pummeled the major indices, I found myself focused squarely on the Russell 2000 index. Up to that moment in time, I hadn't fully realized the importance of small-cap stocks in the ultimate success or failure of the post-March recovery effort.
But it's clear this group holds all the cards when it comes to market direction from now into the fourth quarter. In particular, a Russell rally would bolster the Nasdaq Composite, as dozens of small-caps turn green and move higher. The same dynamic would also expand market breadth, which has weakened considerably in the last 15 months.
The iShares Russell-2000 Trust
(IWM)
shows decent upside since March, but the bearish setup is easy to see when looking at a one-year chart. During this period, the fund has bounced off two-year lows and retraced 50% of the July into March selloff. But sadly, it's still trading under the deep lows posted last August and November.
Like the Nasdaq-100 index, the Russell rallied into the Jan. 4 down gap and filled it during last week's options expiration-driven rally. Notably, this is the last big hole created by the credit-induced downtrend. It's the type of event that tends to generate a host of sell signals in the technical community.
Recent price action shows intense conflict with neither side gaining the full advantage. Notably, the filled gap also corresponds with resistance from the 200-day simple and exponential moving averages. This triple barrier has induced the spiking volume we've seen in the last week.
Despite recent selling pressure, it's premature to rule out an eventual victory by the bulls. Accumulation, as noted by on-balance volume, has risen to its best levels since February. Additionally the pattern off the lows shows a series of higher highs and higher lows, so the recovery effort has been bent but not broken so far.
The greatest concern in this view is the rapidly declining price rate of change, illustrated by the rising wedge pattern that has been in place for the last month. Each high in the series show less thrust and conviction than the last one, raising the odds for a sudden breakdown marked by a wide range price bar that drops all the way to 70.
Until we see a major breakout over resistance at 75 or the vertical selloff into 70, this instrument is best suited to the skills of scalpers and daytraders, as opposed to investors and position traders. Frankly, we have to favor the bears, because waning momentum is showing up throughout the price/volume structure.
If you spend time flipping through the charts, you know the Russell 2000 index isn't the only instrument grinding through a similar bilateral setup. In particular, the S&P 500 rose above 200-day moving average resistance last week, where it stalled out and failed to print the decisive rally that would have confirmed the start of a new bull impulse.
Until we get bullish confirmation on the S&P 500 and Russell 2000 indices, investors need to walk on eggshells while traders sit on their hands and wait for better entry signals in either direction. My guts tell me the next big move will be to the downside, but I'm going to stifle that negative bias for now and just take what the market gives me.
At the time of publication, Farley had no positions in the stocks mentioned, although holdings can change at any time.
Farley is also the author of The Daily Swing Trade, a premium product that outlines his charts and analysis. Farley has also been featured in Barron's, SmartMoney, Tech Week, Active Trader, MoneyCentral, Technical Investor, Bridge Trader and Online Investor. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.
Farley appreciates your feedback; click here to send him an email. Also, click here to sign up for Farley's premium subscription product, The Daily Swing Trade, brought to you exclusively by TheStreet.com.
TheStreet.com has a revenue-sharing relationship with Trader's Library under which it receives a portion of the revenue from purchases by customers directed there from TheStreet.com.
