Pinnacle Business Management (Prev SRCI)

[SloJon]

Divergence alert in US stock indices:
comparing the Russell 2000, S & P 500,
NASDAQ 100 and DJIA 30
Jeffrey Robert Hunn
I see an alert signal in the charts of the major US indices. Incidentally, I think the alert signals an imminent decline, and perhaps very large.

Why? I have been comparing the charts of four US indices. Within the historic transition of the last few years, the last few months have also developed an unusual pattern. Before I detail the pattern, here is some background information on stock indices.

Review of select US Stock Indices

To understand the pattern, we can first recall the nature of the 4 indices. The Dow Jones Industrial Average (DJIA) is composed of 30 prominent stocks. The Nasdaq 100 (or QQQ) is composed of more than three times as many stocks, all for large companies, about half of which are "hi-tech" companies. The S & P 500 (SPX) includes 500 of the largest companies in the US, and thus is much broader than QQQ or DJIA.

Finally, the Russell 2000 (RUT) reflects a couple thousand companies in the US and does not include any of the largest 1000 companies. While DJIA, SPX, and QQQ all overlap to include some of the same major companies like Microsoft, RUT does not overlap with any of those 3 "major" indices at all. RUT is not a "minor" index, but is the least major and thus most "junior" of the 4.

How long is a company included among the 30, 100, 500, or 2000?

Before moving on, it bears noting that a company used to calculate each index at one point is typically used for over a decade. Which stocks are included in each index can change a few times a year or even more. For instance, many of the companies that were among the Nasdaq 100 three years ago are now out of business. Their stocks fell to zero and they were replaced with companies still in business.

To put that in perspective, I recently read that one company has been included in the DJIA for over 75 years: General Electric. When GE was first included in Mr. Jone's index of industry leaders, there was no NBC or MSNBC, both of which GE owns. On the other hand, many of the "industry leaders" from 75 years ago are no longer in business. Some of them did not make it through the 1930s. Similarly, there is no guarantee that GE will be among the DJIA 30 in one year- or even in business.

Review of the last few years (featuring RUT)

So, in the last four years, QQQ (which tracks the Nasdaq 100) has rocketed up and then plummeted. At their all-time highs in early 2000, QQQ and RUT both went up as SPX and DJIA both went down.

That is, there was a divergence as QQQ and RUT rose while SPX and DJIA fell. DJIA never recovered to approach the 12000 mark as it had at the very beginning of Y2K, while SPX immediately surged to its all-time high (over 1500) on spring solstice of 2000.

While QQQ, SPX, DJIA and most other major stock indices around the world have plummeted in the last 4 years, RUT is currently flat: basically a 0% change (before adjusting for inflation). Why is it doing so well (relative to other international stock indices)?

Of course, it had the big rise in early 2000 when SPX and DJIA dropped. DJIA had already topped and investors apparently fled the 30 "industry leaders" for both QQQ and RUT. So it was a little ahead- but so was QQQ, and look at QQQ now.

Here is the key. For virtually every rally of the last 3 years, especially the big late 2001-early 2002 rally, RUT went up very firmly. While the movement of a single high-dollar company can drive the major indices, RUT has 1999 other stocks to keep it steady.

Indeed, it may be that every rally of the last few years has ended liked the bull market apparently did in 2000: investors were quick to flee the "industry leaders" for RUT and slow to sell those smaller-cap stocks. Of course, by industry leaders, I do not just mean the DJIA 30, but of course the Nasdaq 100. In late 2000, QQQ investors apparently left US stocks altogether (QQQ dropped along with the other US indices), but in early 2002, the drop in QQQ was accompanied by a rise in the DJIA and RUT, and then when DJIA fell, RUT kept on going up.

So, it seems that investors have been selling RUT last (if not least). More recently, investors bought QQQs first, but piled in to RUT in the last few months- then stopped.

Review of the last few months

A few notes are all I will add to the above chart. After rallying to a 50% gain on June 6th at an unusually high volume of 3 billion, the NASDAQ is down. The volume was trending up for over a week and then dropped to "average" volume for now over a week.

While Nasdaq "got ahead" in the Fall of 2002, it has actually been in line with SPX and DJIA since then. Indeed, from mid-March to mid-April (the start of the "war mania"), QQQ was the most stable of the 4. That is very unusual.

For the last few months, especially obvious in May and June, RUT has rallied the most. That is even more unusual.

Review of the last few weeks

From the peak on Friday June 6th, all the indices fell for more than a day- with most of the decline happening from 10 am Friday to 11 am the next trading day. Since then, we witness yet another divergence.

After 5 days of rallying, DJIA was up 1% from the 6/6 high and SPX had equaled the peak, while QQQ and RUT were each about 2% down. Is this a continuing rally? Not for QQQ and RUT- at least not yet.

Again, RUT reflects 2000 relatively stable stocks compared to 30 in the DJIA. When I look at the above chart, I don't see a continuing rally, but a divergence punctuated by QQQ and RUT.

After more than 5 days, RUT has recovered half of the losses from a decline of more than 1 day. That is not consistent with the pattern of the previous months (the 30% rally). Not only is it unusual for RUT to lose 4.5% in less than two days, but it is also unusual for it NOT to make higher highs.

Looking at the black line above, we see that RUT had a secondary peak in the afternoon of 6/6. Last Tuesday, it approached that level twice and fell sharply each time. Yesterday, two more failed rallies. (The first rally yesterday followed the release of a news item that seems to have been forgotten already.)

QQQ has also failed to return to the highs of 6/6, when volume also peaked. Has the multi-month rally run out of momentum?

Review of the last few days

As of 2:12 EST on 6/17, RUT has still failed to show any signs of approaching anywhere near the 6/6 high. Looking at the lower portion of the above chart ("% Compare"), it looks like the divergence may have reached its extreme early this morning.

RUT has clearly faltered in its multi-month, 30% rally. It is no longer leading the indices higher.

That can change, but along with other factors not elaborated in this "chart analysis" article, I suggest that the change may have already happened.

SPX and DJIA broke their "channels" on 6/6 (see article from 6/9), but have reversed to continue in a wider channel up. This may suggest an excellent opportunity to sell ANY of the indices (to conserve profits and/or enter "inverse" positions).

With the current divergence, I would be very hesitant to purchase even stocks for short-term rallies- certainly not until RUT and QQQ substantially exceed their 6/6 highs. (Or, very short-term daytraders could ride any break of RUT's 459 resistance with very tight trailing stops.)

Rather than a series of new highs, I expect a possibly very large decline, starting with a break of this morning's low. If the drop is sharp- perhaps even sharper than that of 6/6 and 6/9- day trading the declines with tight stops can be very profitable very fast. Tight stops are the best way to preserve assets, and are most profitable when combined with clear re-entry indicators.

Of course, in times like these of divergent, mixed signals, the most conservative investors will either favor cash for the moment (FOREX rates for the dollar have apparently stabilized and may even rally) or favor tight stops targeting a series of (relatively) small gains. Then again, the very most conservative investors are likely hoarding gold and silver about now, but moderate exposure to a broad range of stocks may also be prudent, especially "short" positions (including inverse or "bear" funds and "put options").

If this is not what your account managers are telling you about, it may be time to change. If you would like to know more about hedge funds targeting reliable, short-term gains by using tight stops, I can provide more information to you about the most conservative strategies available. For assistance or feedback, you are welcome to email me at [e-mail] or leave a message at [phone].

� 2003 by Jeffrey Robert Hunn�
http://jrhunn.0catch.com

June 18, 2003