The Nasdaq Looks Stretched

 | Jul 13, 2014 | 7:00 PM EDT
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The markets are quite funny in some ways. The generally accepted wisdom says market players always act upon news as soon as it hits the tape -- yet that is not always true.

Several weeks ago, two Bulgarian banks failed and the market whistled right by. Folks ignored it, barely even considering it news. Then, just before July 4, European markets fell slightly after an Austrian bank announced a shortfall based on poorly performing Hungarian loans.

Following that, U.S. markets were down somewhat last Monday as several folks in the media noted that Portugal yields were on the rise -- but there was very little chatter on that specifically. In fact, Tuesday's news flow in the U.S. markets was all about the falling momentum stocks, and not about Europe or European banks. Yet, by Thursday morning, folks suddenly thought we had a new European banking crisis on our hands -- because of Portugal.

I am not saying these banks are all connected, but have you looked at some of the action in the European banks this year? I won't even bother with Barclay's (BCS), since it has been in the news on a practically constant basis. But just look at Deutsche Bank (DB). This stock peaked in January, and its shares have delclined about 30% so far this year. There has barely been a bounce in it. Before you mention the Ukraine crisis, please remember that that erupted in late February, not January.

It's not as though UBS (UBS) has fared so well, either. This stock peaked in March, and while it has at least seen some decent rallies, it too has performed terribly. Its major slide came right after that early-June promise of further intervention from European Central Bank President Mario Draghi. UBS shares are down "only" 15% from their peak -- but, again, amid last week's hysteria over European banks, this stock barely reacted.

All this aside, let's turn to a chart from the U.S. markets: the ratio of the S&P 500 to the Russell 2000. That ratio, which I often discuss, is currently at 1.71. We tend to see very good intermediate-term bottoms when the ratio gets to 1.75: In mid-May, for instance, a nice short-term oversold rally came after it peaked at 1.72. So I still believe that, had it been able to get closer to 1.75, the rally would have been of better quality.

Now let's look at the ratio of Nasdaq relative to the Russell. This is currently at 3.82 -- its highest level since its peak on April 10, 2012. Back then, the Nasdaq itself had actually peaked two weeks prior to that, and shortly afterward it went into a 12% correction.

The ratio did not quite reach that level again in August of 2012, and once it climbed it hung around for just over a month. After that initial peak, the Nasdaq actually embarked on a 6% rally, but in September the index hit a high and headed down for another 12% correction.

My point is that, in that year, this ratio once peaked once after the Nasdaq did, and in the other instance and it hit a high well beforehand. So the timing was not perfect for either instance -- but it sent the same message both times: The index was stretched.

We often hear that the news isn't what's important but, rather, the market's reaction it. In the case of the European banks this year, those stocks had already been so down and out that they had pretty much shrugged at last week's news. As for the Nasdaq-Russell ratio, there is probably some piece of as-yet-unknown news that will cause the ratio to get back in line by either driving the Russell up or the Nasdaq down. You can choose which one you think it is.

Either way, based on the indicators I would still lean toward the correction camp, even if you can make the case that the Nasdaq is oversold in the short term.




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