Expect Nasdaq’s erratic rally to end in tears

As any cynical City boy will tell you, a severe bear market in shares is far worse than divorce. You can easily end up losing half your wealth, but without the benefit of getting rid of your wife. Faced with such trauma, both soon-to-be-singles and investors often go into denial. As a result, early-stage bear markets can be hesitant affairs. Following initial weakness, an index can pause or even rally for a while, as people tell themselves that their relationship with equities isn’t headed for the rocks.

Such pretence seldom withstands closer scrutiny. While the Nasdaq 100 has bounced strongly off its August lows – recently coming within 4 per cent of its bull-market highs at 2,438 – there are clear signs of trouble in paradise. A genuine uptrend is typically smooth and thrusting, but the Nasdaq has advanced via a series of violent gyrations. When this happens, the rally normally ends in tears, with a sharp move down to new lows. Like any financier’s trophy bride, the Nasdaq 100 does not come cheap. It is at its highest level relative to the S&P 500 index since the technology bubble of the late 1990s. In the event of a big bear market in US equities – which I believe is the most probable outcome – this gap would almost certainly close, with the Nasdaq underperforming its rival significantly.

So, while the Nasdaq’s price is below its 13-week exponential moving average – and that line is also declining – my bias would be to take short positions in the index. Currently, this average is around 2,200 and is more or less flat. Once the Nasdaq drops decisively below this, I expect the index to revisit its August lows at 2,035, before heading for 1,898, 1,734 and 1,568. I do not envisage a major low occurring in US stocks until at least the summer of 2012.

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