Structural Decay

Monday, February 23, 2004 | 02:02 PM

We continue to observe weakening pockets in certain sectors of the markets. Momentum continues to fade. In particular, the Nasdaq has diverged away from the mid and small caps, as well as the Dow. While many stocks have been making fresh 52-week highs, the Nasdaq is failing to keep up. This is a bothersome development worth watching closely. The “clear “line in the sand” is the Nasdaq 2000 level. If that’s broken on a closing basis, it will signal the start of a significant corrective action, in our view.

This is especially true, considering the markets are now past the strongest part of their seasonal cycle, with no obvious catalysts in the near future. The next few months may be a bit of a slog. Whether this will be an extended sideways action or the start of something more sinister is not clear, which is why critical support levels are so important.

Several other cracks are starting to appear also. The superb breadth has been noted as one of the “hallmarks of this entire rally.” Even on days when the SPX has been flat, breadth often favored advancers by 2 to 1. Now, Breadth (A/D line) has started to weaken. As the chart nearby shows, cumulative up/down volume is also weakening, reflecting the fading Momentum.

While the markets are not yet in a distribution period, the balance of buyers and sellers is starting to tilt. Since January, average daily volume has also been eroding on the Nasdaq (although not so for the NYSE). Perhaps institutional buyers are losing interest in chasing stocks - especially expensive ones - much higher.

Money flows into equity Mutual Funds were extremely aggressive in January. AMG Data reported that equity funds saw net cash inflows of $40.8 billion in January (71% going to Domestic sectors), similar to the $40 Billion inflow in December 2003. From a contrarian perspective, that is worth noting, as the last time mutual fund inflows were that strong was in the first quarter of 2000. Perhaps you may recall how that did not end well.

When we combine this data with the Nasdaq’s short term January 26 peak, we are left with the conclusion that mutual fund inflows for the month of February are likely to be significantly below those seen in January. Unless this changes, we would expect to see institutional buyers deploying their capital much more cautiously than they have been up to now.

Large institutions account for about 75% of all trading activity. Until fund inflows move back up, the markets could, in our opinion, enter an extended period of consolidation.

Update: February 26, 2004, 12:49 pm
Correction: Mutual fund inflows were $17.5 Billion in December; $40.8 Billion in January; and ithis month, looks to be heading for a sub $20 Billion February. (I committed the cardinal error of using a different data source for January and December . . .) See AMG Data for more info.

Apologies for any incovenience this may have caused.

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