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Nasdaq Weakness Imperils Rally

The semis and small-caps look like they will make or break the market in the fourth quarter.

This column was originally published on RealMoney on Oct. 19 at 12:00 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.

The market's fourth-quarter prospects look great when we limit our analysis to the

S&P 500

and

Dow Jones Industrial Average

, but it's a different story with the Nasdaq Composite and Nasdaq 100.

They face major challenges as we wind our way through earnings season, and this conflicting action could eventually end the rally off the July lows.

Dow Theory examines alignment between the indices to verify longer-term trends in both directions.

In the old days, technicians looked for convergences in the positioning of the Dow Industrials and the Dow Jones Transportation Averages.

However, times have changed and these indices no longer represent the broad range of American industry.

It's more logical to compare the S&P 500 and Nasdaq when evaluating longer-term trends.

In this regard, the broad market still shows a major divergence, because four-letter stocks haven't confirmed the breakout of the S&P 500 according to the tenets of Dow Theory. (See the chart below.)

The Nasdaq Composite played a good game of catch-up in recent months and just hit resistance at its January high.

But too much lightheaded commentary these days assumes that it will break this level easily and join the S&P 500 at new highs.

Such is the delusion we face when bull-market genius undermines logical technical analysis.

Interpreting this resistance correctly demands a two-pronged approach.

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First, assume that the bears are waiting to drag down the composite at least once, fulfilling their vision of a double top.

Second, the rally that follows this pullback will be instructive about the buying power needed to tear through resistance and join the S&P 500 at new highs.

Let's move over to the

Nasdaq 100 Trust

(QQQQ)

to see how its pattern conforms to the broader composite average.

We also have the advantage with this instrument of being able to apply volume techniques to measure underlying accumulation. This type of data is extremely important when price action moves to a contested level, because it shows hidden forces at work.

This instrument looks similar to the composite average and also traded up to key resistance this week.

But note how the composite's highs were hit in March, while the trust's highs were struck in January. This suggests the composite will have an easier time in upcoming weeks than the large-cap-based trust.

Note how on-balance volume has underperformed the price during the three-month rally. This divergence is small but clearly delineated on the chart.

This warns that accumulation is inadequate for the trust to make a strong move above levels hit earlier this year. This also signals the possibility of a downturn that absorbs remaining supply.

Technicians want to see "back and fill" action as markets move higher over time, stair-stepping movement that grinds out building blocks of range patterns which support higher prices and make sharp downturns less likely. There hasn't been a single back-and-fill pattern on the composite or trust charts since the summer lows.

So it looks like four-letter stocks are still vulnerable to a sharp downturn, despite all the crowing about new highs on the S&P 500 and Dow Industrials. Sadly, a Nasdaq rollover could have an unfortunate effect on the blue-chip breakout. This follows a widely held observation that speculative stocks must lead runs to new highs or risk broad-based failure.

But I'm not saying that's going to happen, at least not yet. My cautious approach might drive a few readers crazy, but the market landscape needs to be viewed in multiple shades of gray, where chains of related events determine directional outcomes.

And right now, the market is telling us to sit back and wait until those events unfold.

In this regard, the chain begins and ends with two market groups that determine Nasdaq direction: the semiconductors and small-caps. The fourth-quarter performance of these stocks will send the Nasdaq averages much higher or drop them into a tailspin back toward the yearly lows. Here's my take on these two major contributors.

The

Semiconductor HOLDRs Trust

(SMH) - Get VanEck Semiconductor ETF Report

is best examined in the longer-term view, given the daily cheerleading in the group. This pattern still is relatively negative for chip stocks, despite obvious progress since the July low. In particular, the instrument continues to trade below significant resistance at the broken May top.

It doesn't look like earnings season will bail out the sector, at least from the results we've seen to date. So let's assume that resistance will remain in place, and then plan accordingly. In other words, don't look for chip stocks to help the Nasdaq averages break above yearly levels this October.

Last month, I noted the

iShares Russell 2000 Index Fund

(IWM) - Get iShares Russell 2000 ETF Report

needed to rally

above base resistance to position itself for a run back to its May high. That breakout was finally triggered last week and it's headed toward that level, but the outlook for the fund remains clouded in the short term.

It's still underperforming the Nasdaq averages, which are already at yearly resistance, and accumulation looks totally inadequate for a run to new highs. On the other hand, this chart shows the back-and-fill pattern missing on the other indices. This paints a conflicting picture that predicts the small-cap rally will stall out sometime in the fourth quarter.

At the time of publication, Farley held none of the issues mentioned, although holdings can change at any time.

Alan Farley is a professional trader and author of

The Master Swing Trader

. Farley also runs a Web site called HardRightEdge.com, an online resource for trading education, technical analysis and short-term investment strategies. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Farley appreciates your feedback;

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