Warning Signs for the Nasdaq

The index's pullback—coming on a sharp increase in volume—may signal a 7% to 10% correction

by Mark Arbeter From Standard & Poor's Equity Research

The breakout by the Nasdaq failed and led to an anxious overall tone on Wall Street last week. Bond yields consolidated just below the 4.8% zone while crude oil prices tested the $50 per barrel level.

The warning signs continue to mount that a pullback or correction is coming and we would use any near-term strength to pare back equity holdings, especially those that are most extended. Intermediate-term market tops are usually tough to pinpoint exactly because they take longer than bottoms and they usually do not trace out clean, "no doubt about it" reversal formations so often seen at intermediate-term lows. While the inability to pinpoint a top may seem like a great disadvantage, the market does give the investor plenty of warning to prune holdings and allocate more resources towards defensive issues, which many times do better in a weak equity environment.

Two major indexes that tend to lead the blue chip indexes at intermediate-term market tops are the Nasdaq Composite and the FTSE 100 Index. During the last intermediate-term peak, the Nasdaq reached a high on Apr. 19 while the S&P 500 did not peak until May 5. The Nasdaq's breakout during the second week of the New Year has failed very quickly, often not a good chart pattern for an index or individual stock. Many times after a failed breakout, an index will fall right through the preceding base, and break out to the downside.

In conjunction with the unsuccessful breakout, the pullback has been somewhat sharp and it occurred on an increase in volume. The Nasdaq fell 2.2% on Wednesday, Jan. 17, and Thursday, Jan. 18, with volume coming in at 2.38 billion shares on Wednesday and 2.54 billion shares on Thursday. This volume surge was well above the 50-day average of 2 billion shares, and Thursday's volume was the third highest since June, 2006. We think this is clear evidence of distribution by institutions, and we believe it is just another warning that a pullback/correction is coming.

We think the Nasdaq will drop all the way down to the bottom of its recent base in the 2390 to 2400 range. We then could see an attempted bounce that fails. A strong breakout below this area would finally signal to us that the corrective action was beginning. Just below chart support between 2390 and 2400 sits the 80-day exponential moving average 2386. The Nasdaq has been above this key average since the middle of August and was last crossed to the downside on May 11, just as the 2006 correction was unfolding. In addition, a 23.6% retracement of the rally equates to potential support at 2389.16.

If our overall market call is correct, our expectations are that the Nasdaq will decline 7% to 10%. A 7% pullback equates to a 38.2% retracement of the rally since the July bottom and would take the index to 2318.85. A 50% retracement of the rally corresponds to a 9.6% correction and would lead to a drop to 2262.24. Long-term moving averages reside near these important Fibonacci retracement levels, with the 150-day exponential average at 2327 and the 200-day simple average at 2266.

The FTSE 100 Index has also led the U.S. markets over the years, sometimes at both tops and bottoms. Why, we do not know. Not only did the FTSE top out on Apr. 21, 2006, well before our blue chip indexes, but it also bottomed on June 14, about a full month before the S&P 500 and DJIA bottomed out.

This time, the lead time at the top may only be a week or two. The FTSE broke out to new recovery highs on the first trading day of 2007, about seven to eight trading days before our markets broke out. The FTSE's breakout failed on Jan. 5, about eight days before the Nasdaq's breakout failed. The FTSE has failed to break below important trendline and moving average support, but because of its characteristics as a leading index, it does bear watching.

The FTSE remains perched precariously right above some key intermediate-term as well as long-term supports, so the action over the next month or so should be very telling. The early-year minor breakout to new recovery highs failed and could be a precursor to a pullback or correction.