The recent rally to new highs in the S&P 500 large cap, S&P 400 mid-cap and S&P 600 small -cap is suspect. While higher prices may be offing in the near-term, we believe this rally could be terminal in nature given several divergences are evident. One of these divergences is the Nasdaq Composite/MS Cyclical Ratio ($COMPQ/$CYC); generally $COMPQ underperforms during a market rally as was evident from March 2003. However, $COMPQ has broken out against $CYC by moving above trendline resistance; this clearlyrings a bell' indicating the underlying tectonic plates are shifting; with an absolute trend change is not far off in the distance.
In the short-term, $COMPQ is pulling back in normal fashion to test trendline breakout. But, given the stochastic is oversolda turn higher is expected and for the ratio to resume its intermediate-term trend higher. Thus, if we are to be short into this recent rally we must clearly consider being short the cyclicals rather than technologywhich is counter intuitive technology is the higher-beta group.
