This column was originally published on RealMoney on May 29 at 12 p.m. EDT. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.
The market sold off on Thursday after the major indices spent three sessions trying to break out to new highs. Small-caps led that rally attempt and also got sold more heavily than other sectors during the sharp decline. Does this mark the end of emerging rotation into that underperforming group? And if so, does the rest of the market look prepared to continue this advance?
Right now, it's too early to tell, because every pullback in the last two months has turned out to be a buying opportunity. This puts us into wait-and-see mode while we gauge the depth of supply and demand in the current downturn. Unfortunately, several factors seem to point to the rapidly diminishing likelihood of a continued rally.
Powershares QQQQ Trust
violated its 20-day moving average on Thursday and failed to remount it during Friday's session. This is the first time since March the exchange-traded fund closed below that support level for two consecutive days. Blame the notable rollover on chip stocks, which have dropped like rocks in the last two weeks.
On the other hand, the
are still well positioned to recover and retest their 2007 highs. So the
relative weakness puts us back into a divergent environment where big-caps are leading the market while four-letter stocks lag far behind. But even more trouble is brewing under the surface.
Blue-chips, tech stocks, small-caps and semiconductors all show deteriorating technicals that might signal the start of a major summer correction. Truthfully, I'd welcome that event after the narrowly based big-cap rally we've had to endure this spring. Consider the two primary elements of this unpleasant uptrend.
First, the Dow led all other market groups higher. Typically, big-caps lead at the end of bull markets because big investors flock to these issues as safe havens before economic downturns. Second, the S&P 500's historic 2000 high has been a magnet pulling price higher. Despite the hoopla, this level marks major resistance that could take years to overcome.
Several cautionary observations stand out when looking at May volume on the
. First, on-balance volume topped out on May 16 and failed to make a higher high when the ETF ran to new highs last week. Notably the
SPDR S&P 500 ETF
has a matching pattern, in which OBV also peaked eight trading days ago.
Declining relative strength also points to the possibility of an intermediate top. Note how Wilder's RSI peaked on May 9, right against the 80% overbought level. The indicator has been grinding out an ominous series of lower lows since that time. This is in marked contrast to a persistent rally to new price highs during the same period.
Once again, the SPY matches these generally bearish readings. Together, the instruments point to the end of the blue-chip rally and the start of a correction that will give up an unknown percentage of the March-to-May gains. These are particularly strong signals because the funds represent the primary leadership of the spring rally.
Last Chance for Small-Caps?
What could save the market from a downturn here? That's easy, because the answer hasn't changed in the last two months. Simply stated, the small-caps need to get their acts together immediately and take over market leadership. Unfortunately, these stocks are running out of time to accomplish this lofty goal.
iShares Russell 2000 Index Fund
showed growing signs of leadership when it lifted off the 50-day moving average on May 18. The fund outpaced the S&P 500 and Dow Industrials during the next three sessions, while all major groups tried to break out to new highs. But Wednesday's reversal and Thursday's selloff indicate that this effort has failed.
The small-cap fund could take a fresh shot at the highs, given its current positioning, but the mission will be even tougher because of transitional deterioration in the blue-chip indices. Add this obstacle to growing weakness in the semiconductor group. In sum, last week's failed rally might have been the last chance for small-caps to break out.
As mentioned, it looks like chip stocks will move even lower in coming weeks. Active distribution began in April and escalated significantly this month. The
is now sitting at 50-day moving average support. But this level will probably break and trigger a secondary decline that fills the April 18 gap under 35.
I haven't been a fan of the spring rally because the ticker tape has been undependable, unless you're holding multinational big-cap stocks. This poor quality of price action just isn't supportive of a broad bull advance. So I'm looking forward to a midyear correction as a golden opportunity for the market to generate more mainstream leadership.
At the time of publication, Farley had no positions in the stocks 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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