The Nasdaq's 50% Solution

03/10/05 11:03:29 AM

by David Penn

While the Dow and S&P 500 soar toward new highs, the Nasdaq continues to lag behind.

Security: $COMPQ
Position: N/A

It's worth saying this much at the outset: on the one hand, we have the Dow Jones Industrial Average (DJIA) setting a new high for the year, and getting some observers thinking that new ALL-TIME highs might not be too far away (a la 1972).

And on the other hand, we have the Nasdaq composite--which is struggling to get above the 50% retracement level from its January 2005 correction. (See Figure 1.)

Figure 1: What could have been a rally to recoup January losses turned into a sideways consolidation as the Nasdaq met stiff resistance at the 50% retracement level.

Graphic provided by: Prophet Financial, Inc.

There is a temptation to state the obvious--and a temptation to avoid stating the obvious. I'll succumb to the former: It is hard to imagine stocks in general continuing to move higher as long as the Nasdaq is unable to retrace more than 50% of its previous decline.

The 50% retracement level is perhaps the king of retracement levels. This level is among those highlighted by traders using Fibonacci retracements, and also appears as a component of Dow theory when trying to determine the significance of countertrend market moves. Here's noted Dow theorist Richard Russell talking about what he calls the "50% principle":

"I gleaned the 50% Principle from the great Dow Theorist, George Schaefer. Schaefer stated that he dug up the 50% Principle from his study of Dow's writing. At any rate, what a major average does ... at the 50% or halfway level of a major advance or decline is critically important. Example--on a decline it's important to note whether the Dow halts above the halfway level of the preceding advance. If, on a decline, the Dow can retain 50% of the ground gained on the preceding advance--that's a bullish situation, and often leads to a test of the highs again.

"On the other hand, if the decline wipes out more than half of the preceding advance, that's a bearish situation and the Dow will usually go a good deal lower."

By this criterion, the Nasdaq's post-January bounce has not been very encouraging for the bulls. True, the January decline may or may not qualify as a "major decline," shaving as it did 8% off the late December/early January highs. But the fact that the Nasdaq has repeatedly failed to break above its 50% retracement level suggests that the level is worth watching in any event.

In this regard, the table is set for Nasdaq traders. If the Nasdaq makes it above its 50% retracement level, then the benefit of the doubt will certainly have to be given the bulls for thinking that a retest of the 2180 might follow shortly thereafter. However, if the Nasdaq continues to fail at the 50% retracement level, then it is hard not to believe that a test of the January lows south of 2020 will be in store.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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