Nasdaq relative strength not necessarily bullish

joeblack

http://www.marketwatch.com/news/ ... ly/story.aspx?guid={55AF6813-3EAD-4D12-870B-578D89F8E5B2}

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The Nasdaq's relative strength is quite striking, in fact. The Nasdaq Composite Index is now in positive territory for the year, with a 0.6% gain since the end of 2008.

The Dow, in contrast, is nearly 10% lower.

Unfortunately, those who are making this bullish argument are committing several major errors.

The first is believing that the Nasdaq Composite is a good proxy for the small-cap sector. It isn't. A stock's weight in the index is a function of its market-cap, so a relatively small number of very large Nasdaq-listed firms dominate the index -- companies such as Microsoft Corp.

Unfortunately, indexes that are more representative of the small-cap sector are not showing any relative strength. Year-to-date, for example, the Dow Jones Wilshire U.S. Large-Cap Index has lost 6.4%, exactly the same as the return of the Dow Jones Wilshire U.S. Micro-Cap Index, and even better than the 7.5% loss of the Dow Jones Wilshire U.S. Small-Cap.

The same story is told by the indexes maintained by Russell Investments. The Russell Top 200 index of the 200 companies with the largest market caps is down 7.2% for the year, while the Russell 2000 Index of small-cap stocks is down 10.5%, and the Russell Micro Cap Index is down 10.8%.

You might not care that the Nasdaq is a poor proxy for small stocks if it is nevertheless bullish when it is outperforming the largest-cap stocks.

But it isn't.

Care to guess when it was that the Nasdaq Composite Index exhibited the greatest strength relative to the Dow over the trailing quarter? That's right: It was in March 2000, at the very top of the Internet bubble.

I shouldn't have to tell you what happened next: The troops led the generals, all right, but it was over a cliff.

That's just one data point, of course, even if a spectacular one. But, even after feeding four decades' worth of data for the Dow and the Nasdaq Composite into my PC's statistical software, I still found no strong statistical support for the notion that the Nasdaq's relative strength over the trailing quarter is bullish. (To be sure, the Nasdaq's relative strength isn't bearish, either. Its relationship to future market returns is largely random.)

None of these results guarantees that the bear market is still alive.

But if you're basing your bullishness on relative Nasdaq strength, you may want to reconsider.