Market Won't Rebuild Confidence Soon

There are times when virtually every indicator of market behavior is pointing in the same direction. Now happens to be one of those times. We are talking here about intermarket relationships that reflect confidence, or in this case, lack thereof.

In early May, I wrote about the potential for a technical breakdown in the ratio of the Nasdaq 100 to the Dow Jones Industrial Average. The break came a few weeks later, and this weak trend has extended in the last month or two.

The idea in the initial column was twofold.

First, if the ratio broke to the downside, traders could go long the Dow Diamonds (DIA - commentary - Cramer's Take) and short the Nasdaq 100 Trust (QQQQ - commentary - Cramer's Take). I felt at the time that the market would be vulnerable, but regardless of its direction, this would be a great place to hide in case prices started to drop.

The second point was that trends in this intermarket relationship often follow that of the market as a whole. For example, the ratio rose during the 1990s, indicating confidence, because stocks contained in the Nasdaq 100 are more speculative in nature than those in the DJIA.

The relationship fell during the bear market following the bubble's bursting, and rallied again in the October 2002-May 2006 bull market. The recent break below its 65-week exponential moving average (EMA) and uptrend line is, therefore, a bear signal for the overall market, because it indicates that traders and investors no longer have the confidence to make it possible for the Nasdaq 100 to outperform.

The lower series in Chart 1 also reflects a lack of confidence. This one measures the ratio between small- and large-cap stocks. Once again, small-caps have a tendency to do better in a bull market than large-caps. Put another way, when people lose confidence, they tend to go for the more defensive and safer stocks that have a more substantial sponsorship. I emphasize the word "tendency" because this relationship does not hold true all the time; there are occasional bull markets when the large-caps outperform their smaller brethren and vice versa.

Click here for larger image.

Source: Pring.com

In any event, the recent downside break in this relationship not only tells us that large-caps are likely to outperform small-caps, but is another indicator of a growing lack of confidence in equities.

Chart 2 features two more "confidence" relationships. The first is the ratio of the Russell 2000, a small-cap index, to the S&P Composite, a large-cap one. To some extent, there has to be some double counting between this and the small-cap/large-cap ratio in Chart 1, but the decisive breakdown in this relationship below the 2003-2006 uptrend line and 65-week EMA is undeniable.

Finally, the lower panel in Chart 2 compares the Technology Select Sector SPDR (XLK - commentary - Cramer's Take) (speculative) to the Consumer Staples Select Sector SPDR (XLP - commentary - Cramer's Take) (defensive). Once again, we see a similar pattern where the speculative technology is now being out performed by the defensive staples.

Click here for larger image.

Source: Pring.com

All four of these trend breakdowns in confidence have just taken place in the last few weeks. But because the signals are long term in nature, it looks as if we may be in for some hard times in the months ahead.

Rather than end on a negative note, Chart 3 might offer some hope and the potential for opportunity, especially from a contrarian aspect. It features the ratio of the Utilities Select Sector SPDR (XLU - commentary - Cramer's Take) to the Energy Select Sector SPDR (XLE - commentary - Cramer's Take). In effect, it pits a sector that benefits from deflationary conditions against one that benefits from tight economic conditions when commodity prices are rising at a fast clip. When the ratio is falling, it suggests inflationary conditions, and when rising, a deflationary environment.

Click here for larger image.

Source: Pring.com

At the moment, the intermediate KST, a smoothed momentum indicator that monitors trends lasting six weeks to nine months, is in a very positive more. Its long-term counterpart, which reflects primary trends of nine months to two years, has started to turn, but is not yet positively above its 26-week EMA.

As of Friday's close, this relationship was right at two converging trend lines and its 65-week EMA. A rally above this resistance to, say, to 0.63 would signal to me that Utilities have begun a period when they will start to outperform energy stocks. It would also most probably result in a positive long-term KST buy signal. An upside breakout would not mean that utilities are to rally and energy decline, merely that utilities will outperform energy.

The signal has not yet been given of course, but if it is, the strategy would be to go long the Utility Spider and short the Energy Spider. If the signal is valid, and there are certainly no guarantees, you would make money regardless of the trend of the overall market.

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At the time of publication, Pring had no positions in the stocks mentioned, although holdings can change at any time.

Martin J. Pring is president of pring.com, and is actively involved in Pring Turner Capital Group, a money management firm. He also publishes the monthly market letter "Intermarket Review." Pring is the author of several books, including Technical Analysis Explained, and numerous educational, interactive CDs. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Pring appreciates your feedback; click here to send him an email.

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