Nasdaq Could Crack the 2200 Ceiling

This column was originally published on RealMoney on Nov. 4 at 11:14 a.m. EST. It's being republished as a bonus for TheStreet.com readers.

The dramatic advance of the Nasdaq Composite through 2003 ended in January 2004 just shy of 2200. Since then, the tech bulls have pushed the envelope on a few different occasions. Each time, 2200 has held firm. Why? Does everybody start looking at charts and decide to sell their four-letter symbols at the same level they did before? Perhaps it's just some type of broad market overvaluation that I'm not aware of.

While nobody knows why the Nasdaq fails at 2200, I have a thesis that makes sense to me. And it makes me think that we may see this ceiling on the Nasdaq crack soon.

I think the chart represents the general balance of emotional commitment between the bulls and bears -- which side is more aggressive, and which is more passive. This natural ebb and flow of emotions is seen in price patterns. There's nothing magic about the patterns themselves. Rather, they simply reflect the interplay between the various factions in the crowd. As long as the pattern repeats, all is well. But when the unexpected occurs, all bets are off and the dynamics change completely. That is the stuff that breakouts and breakdowns are made of.

We trade a pattern for as long as it lasts, then we adjust our thesis to incorporate the shifting emotions of the crowd (as reflected in the price action).

Let's look at a weekly chart of the Nasdaq.

The abrupt end of the bulls' aggressiveness is evident in the yellow areas, but look at how each low is established at increasingly higher levels. What does this tell us about the relative emotions of the bulls and bears? The bears are becoming more and more passive with each pullback.

Another way to view it is this: The number of bears is decreasing as the number of bulls is increasing. The 2200 level is still the point at which the bulls tire out, but with the most recent shift in emotion occurring at around 2025, the chances are excellent that the current bullish trend will last long enough to push above 2200.

A breakout above 2200 would obliterate the current predictable pattern and catch a lot of people by surprise. Fear of missing the new trend would prompt more and more bears to switch sides, thereby creating additional buying pressure.

That's my conditional thesis. And if the Nasdaq again fails at 2200 and falls beneath support, the dynamics shift in different directions. But that's for another time.

Let's look at a few charts.

Talk about an abrupt shift in the balance of aggressiveness and passivity! As of last month, over 5% of the float in Molecular Devices(MDCC) had been sold short. But an upside surprise in earnings eliminated any more downside in the stock price. The shorts (bears) had to cover, and they have been competing with natural buyers (bulls) for shares. This rush to buy MDCC has pushed the stock up more than 25%. However, I think this round of buying is over.

Notice that yesterday's high volume was accompanied by a closing location in the middle of the range. That is indicative of a bull-bear battle. After a multiday rally, the bulls are spent. My bet is that the stock pulls back -- the short squeeze is over. Let's get a better perspective by looking at the weekly chart.

The $25 level brings out the bears. That's where MDCC reversed last time. So I wouldn't be a buyer now -- there's no remaining upside. And even if the stock breaks above $25, the run has just been too fast. There are better opportunities elsewhere.

The downtrend in the homebuilding sector has been reversed over the past week or so. Pulte Homes (PHM) bottomed at $35 in late October and is now above $40.

The horizontal section on the chart around $42.50 illustrates the volume-weighted average price. More shares have been traded at the $42.50 level than anywhere else. And since the initial break was to the downside, there are a lot of unhappy bulls who were caught leaning the wrong way in September. They are happy to unload their stock and get most of their money back. That's probably why the stock closed lower Thursday. Anxious sellers were waiting in the wings and gave all the late buyers as much stock as they wanted.

Computer Sciences (CSC) is just a little further along in the selling process. Rumors of a buyout converted a lot of bears to the bull camp. But it happened so fast that there was no one left to buy. So the bulls that were long have been anxious to exchange their stock for cash, and they are increasingly willing to take a less favorable exchange rate -- they just want to sell the stock. So absent an offer by Lockheed Martin( LMT ), profit-taking should cause the stock to fall further.

By explaining the charts this way, I hope I've given you a better understanding of how I use charts to analyze the supply and demand dynamics of a stock.

Be careful out there.

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