Tech Leaders Face Big Test

Monday's dip aside, the stock market has been chugging along for the past few weeks despite technically overbought conditions, too-complacent investor sentiment and other technical signals that typically coincide with a downside correction. I believe this continued strength is largely due to the recent surge in tech stocks (as represented by the Nasdaq 100) and, to a lesser degree, strength in small-cap stocks (Russell 2000).

However, if tech blinks this week -- when bellwethers such as Intel (INTC), Yahoo! (YHOO), Motorola (MOT), Google (GOOG) and Microsoft (MSFT) are slated to report earnings -- we could see a potentially sharp downside correction.

One measure of overbought conditions can be seen in the excessive amount of new highs vs. new lows in the most recent 26-week period. This is simply new NYSE highs for the past 26 weeks divided by new highs plus new lows. Once investors collectively get this bullish, it usually means the party is over, at least for the near term. In other words, the market is a little too happy right now, and most of that happiness has been in tech. Note that the past three times this indicator was at a similar level, it coincided with sharp drops in the market (see the chart below).

Too-complacent investor sentiment is indicated by extremely low options volatility. Options volatility is indicated by the CBOE Market Volatility Index (VIX), which ended last week at a 10-year low. This means that virtually no one is interested in buying any insurance against lower prices in the U.S. equity market. Once again, everyone is too happy right now, and historically, when investors are this happy and carefree, bad things are usually right around the corner. (On Monday, the VIX rose 4.3% to 10.77.)

All of this is just plain-old human nature. Once we all begin thinking the same way and believing we have everything all figured out, things change and remind us that we're really not so smart after all. This is why, since its inception, the stock market has managed to keep most investors ripping their hair out.

Forewarned Is Forearmed Stocks have fallen sharply the three prior times new highs vs. new lows have been at current levels.

Source: Metastock, Asbury Research LLC

Since the market bottomed in October 2002, tech stocks (and to a lesser degree small-cap stocks) have been the spark plug that has made the stock market move. Tech stocks, as represented by the Nasdaq 100, have literally outperformed the broad market -- i.e., the S&P 500 -- every day since July 1. Goosed by its tech components, the S&P 500 has essentially headed straight north since then -- effectively dragged higher by the group's leadership. However, the relative strength line of the Nasdaq 100 vs. the S&P 500 is quickly approaching its December 2004 larger trend of underperformance (the red line in the upper panel of the chart below). If tech stalls at this line, even temporarily, the broad market will lose its spark plug and could correct lower in a hurry.

Tech Rubber Meets the Road The Nasdaq approaches its long-term trend of underperformance.

Source: Metastock, Asbury Research LLC

Yahoo! Holds the Key

One tech stock worth watching is Yahoo!, whose second-quarter earnings are scheduled to be released on Tuesday. After peaking in December 2004, Yahoo! has been coiling sideways ever since. This coiling, contracting price activity is a normal reaction for a stock that has essentially been going straight up since October 2002, and basically represents the market taking some time to digest its gains and to ponder its next trending move.

Most of the time, these patterns are continuation patterns, meaning the stock continues the move that preceded the pattern. However, occasionally they become reversal patterns, in which the stock collapses through the bottom of the congestion area to confirm a top. The upper and lower boundaries of this pattern are currently at $38.75 and $34.25 per share. Two closes through either level will indicate that either the 2002 uptrend has resumed and Yahoo! is headed to at least $47 per share, or it has topped and the stock is headed down to at least $25 per share.

Yahoo! has been 87% positively correlated to the Nasdaq 100 since 1996, which is pretty close to lockstep. Thus, as goes Yahoo!, should go the Nasdaq 100 and, as discussed above, as goes the Nasdaq 100, should go the broader market.

Poised to Move Yahoo! looks ready to move dramatically, and its direction will likely be a key tell for the Nasdaq.

Source: Metastock, Asbury Research LLC

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