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2006 Stock Index Comparison
The Smart Profits Report: Issue #376
Thursday, December 7, 2006
2006 Stock Index Comparison: Here’s How To Play Both Correction or Breakout Scenarios
By D.R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research
As 2006 winds down, the year has given us three distinctive market moves:
- A modest move up in the broader indexes from January to late May.
- A very hard move down from May into mid-July.
- A strong move up from July until now.
In the best of all possible worlds, as traders and investors, we’d now like to know two things: “Which direction will the stock indexes head from here?” & “Where would be the best place to invest?”
One great way to get some insight into those questions is to look at a 2006 stock index comparison and see if their relationships to each other is telling us anything. And right now, these indexes are sending some pretty clear signals.
A Dangerous Stock Index Game of “Follow the Leader”
Remember the playground game of “follow the leader?” It’s great fun - and is even more fun, depending on the how interesting and exciting the leader decides to act.
But have you ever been playing the game when the leader stopped leading? Chaos ensues, and everyone goes off to do their own thing. We’re on the verge of having the same thing happen in the equities markets.
Since the market bottomed in October of 2002, small-cap stocks (represented by the Russell 2000 Index) and the Nasdaq have led the upward charge. Here’s a chart showing the performance of each of the four major stock indexes, with their percentage returns since the October 2002 lows:
As you can see, small-caps and tech stocks have led an impressive multi-year rally. But the problem now is that their leadership is fading. And the chart below, showing this year’s activity in the four indexes, illustrates this well:
In the first upswing of the year, the Russell 2000 clearly outperformed all the other stock indexes, while the Nasdaq lagged slightly. During the midyear pullback, the Russell 2000, S&P 500 and Dow all gave back their earlier gains, while the Nasdaq endured a significantly bigger drop.
In the current rally, the small-caps have performed well, but have not outpaced the Dow or S&P by a significant amount. And the Nasdaq is still a significant laggard, because the hole it dug at midyear was so deep.
Playing Correction or Breakout Scenarios: Where To Place Your Bets
What insights can we gain from the recent movement of the major stock indexes?
- Market Correction Scenario: If the market heads toward a correction, the best shorting opportunities will be in the tech sector and the small-caps. Easy shorts will be in the broad index ETFs: The QQQQ’s for the Nasdaq and the IWM for the Russell 2000.
- Market Breakout Scenario: If the market breaks out to new highs, look for the Dow to continue to lead the way. However, the flight to quality stocks (meaning money moving away from the tech and small-cap sectors and into blue chips) seems to me to be more of a precursor to topping activity than an indication of an extended bull run.
Good Trading,
D.R. Barton Jr.
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Today’s Smart Profits Cribsheet
- Just because the stock market is in the midst of an outstanding bullish upward run doesn’t mean you should join in this dangerous game of “follow the leader.” With little economic news driving such a strong run, it’s important to not get complacent. For my tips on how to spot the pullback signs - and what to do when the market inevitably corrects check out Smart Profits #365, Dow Jones Industrial Average: Don’t Be Fooled By The Dow’s New Highs & Beware The Pullback Signs.
- Over 100 years ago, Charles Dow came up with the foundation for what would become the most powerful and commonly-used investment theories, the Dow Theory. But it was actually his understudy, Wall Street Journal editor William Hamilton, who refined and expanded the concept. For more information on this theory check out Smart Profits #362, Dow Theory: The Most Important And Powerful Concept in Technical Analysis.
Related Articles:
- The Strongest Six Months of The Year for Stocks: Will The Market Spring A Cyclical Surprise?
- Risk Management and Position Sizing: Three Ways To Give Your Trades A Tune-Up
- Large-Caps Stocks: How Point Spread Shows Large-Caps Re-establishing Dominance
The Chart of the Week
Tech bellwether Microsoft (Nasdaq: MSFT) has run into whole number resistance at $30. The stock has enjoyed a great run and could be one of the forces of that pulls the indexes down if it doesn’t gain some traction here. You certainly wouldn’t want to put any new money to work here without a close above $30.
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