The Odd Divergence

The NASDAQ has underperformed the broader NYSE index over the past three months which is usually a bad sign for the bulls.  According to Gerald "MACD" Appel, the NASDAQ/NYSE ratio can be used to judge the health of the market.  In his book, Technical Analysis:Power Tools For Active Investors, Appel builds a basic indicator using the monthly NASDAQ/NYSE ratio.  When the ratio turns higher, the NASDAQ is outperforming and the market is in bullish mode.  When the ratio turns lower, the NASDAQ is underperforming and the market is in bear mode.  The indicator works because when the ratio is heading higher, investors are buying growth stocks and are willing to accept higher levels of risk.  When the ratio turns down, investors are becoming more defensive and are less willing to accept risk.  Right now, the ratio is flashing a caution signal.  That doesn’t preclude the NASDAQ from moving higher, it just indicates that not all is well in the market. 

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The market created a similar divergence at the top of the market in March 2000.  While the NASDAQ rallied to test its old highs, the NASDAQ/NYSE ratios remained weak.  This divergence lasted through much of the bear market from 2000 – 2002. 

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And during the 2004 market peak, the NASDAQ/NYSE ratio also forewarned of potential weakness.  While the NASDAQ rallied strongly to new highs, the ratio made a lower high. 

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While it’s not a great timing indicator, it is a warning sign that investors should stay alert for a potential top.