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Only One Direction Can Be Right

NEW YORK (TheStreet) -- Markets are down Wednesday, but the Dow and S&P 500 recently set new highs while the Nasdaq and Russell 2000 continued to struggle; only one of these directions can be right.

The big question going forward is whether the Russell 2000 and the Nasdaq can reverse course and re-synch with the Dow and S&P 500, which had shown strength. Details of recent market action are below, but first the upshot:

Because it is no longer 2013 and the Fed is tapering its bond buying program, it's probably not realistic to expect the Nasdaq and Russell to climb back to nosebleed levels. They soared as high as they did because so many "casino stocks" were overpriced.

On the other hand, Monday's trading demonstrated that a large number of investors were "chomping at the bit" to get back to "chasing beta," as we saw Facebook (FB) -- with a price-to-earnings ratio of 77 -- jump 4.52%. As for "casino stocks," gamblers ran Plug Power (PLUG) 4.84% higher on Monday, ahead of its first-quarter earnings report before the opening bell on Wednesday. The stock tanked, thereafter.

The spring stock selloff and its aftermath has caused investors to shun high-risk small-cap and tech stocks, while embracing higher-quality, blue chip-type stocks.

The stock market divergence continued through the first week of May. On May 7, the Dow picked up 117 points and the S&P 500 was comfortably above its 50-day moving average, with a 0.56% gain, closing at 1,878. Meanwhile, the Nasdaq 100 declined 0.28% to finish at 3,546, slipping further below its 50-day moving average of 3,609. Despite a slight, 0.05%  advance, the Russell 2000 ended the day at 1,108 for its second consecutive close below its 200-day moving average of 1,114. The divergence between what used to be called "momentum" stocks and the blue chips had investors worried that the weakness in small cap and tech was a signal that the rest of the market would soon follow the fading trend.

Many commentators were calling it a "split tape," with the Dow and the S&P in one world and the Russell 2000 with the Nasdaq in another. One side or the other was bound to give way. Since the beginning of April, the Dow had been experiencing persistent overhead resistance at the 16,600 level, unless that could be broken, it was a bad sign.

On May 12, all of the indices advanced. The 0.68% surge by the Dow was the weakest of the group, although it was enough to punch a big hole in the 16,600 resistance level, as the Dow closed the session at 16,695. The S&P 500 was back to its old habit of hitting record intraday and closing highs. The Nasdaq 100 made a 1.60% jump to close above its 50-day moving average for the first time since April 3. The weakling of the group -- the Russell 2000 -- soared 2.39% to close above its 200-day moving average and just 3.53% below its 50-day moving average.

Tuesday's action saw the Dow and S&P 500 make record closing highs for the second straight day while the Nasdaq and Russell 2000 gave up a piece of Monday's gains. Both averages are now above their 200-day moving averages, but still below their 50-day averages.

We can see that the appetite for risk has returned to some degree. How long that appetite will last is another question. However, the biggest question of all is, in which direction will the Nasdaq and Russell 2000 re-synch with the Dow and S&P 500?

The answer to that question will determine if we're heading for new highs or the possibility of a significant correction as similar action between these indexes preceded the meltdowns of 2000 and 2008. Until this question is answered, my approach is that caution is the order of the day.

John Nyaradi is Publisher of Wall Street Sector Selector, a financial media site specializing in global financial analysis and exchange traded funds.

At the time of publication the author had no position in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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