Over the last week we’ve witnessed the Nasdaq fall and the Dow make gains. This is a serious divergence and signals a significant threat to the tech rally.

Since July 1st, 2010, the $NDX (Nasdaq 100) has gained more than +30%. During this rally, the steepest pullback was in August/September where the index shed just over -7.5% before resuming the rally. The index also pulled back -4.4% in November, 2010.

The $NDX fell 3 out of 4 trading days last week (the MLK holiday week), dropping -2.4%, while the $DJI gained over +0.5%.

Does this divergence suggest a change in the market environment, and if so, how much deeper can we expect this pullback to go?

The Rules:

When the $NDX 5 day Rate-of-Change < -1.5% AND the $DJI 5 day Rate-of-Change > +0.5%, Buy QQQQ at the Close.

Sell X days later.

From 1.1.2001 to 1.21.2011

No commissions or slippage included.

43 occurrences of this setup, with 17 trades if held the full 50 days.

Right axis shows the % of Winners.

The average trade only goes into the positive on Day 1, and then never returns.

The % of Winners stays beneath 50% most of the time and goes as low as 33%.

There appears to be a significant downside edge here…

To reduce skepticism that these results are random, let’s remove the Dow Jones element. After all, the divergence between the Nasdaq and Dow is what the setup is based on. All the rest of the rules remain the same.

The Rules:

When the $NDX 5 day Rate-of-Change < -1.5%, Buy QQQQ at the Close.

Sell X days later.

From 1.1.2001 to 1.21.2011

No commissions or slippage included.

440 occurrences of this setup, with 45 trades if held the full 50 days.

Right axis shows the % of Winners.

The average trade stays positive over most of the 50 days.

Removing the divergence with the Dow Jones and keeping the negative 5 day ROC requirement to trigger a buy on the QQQQ generates a positive edge. Thus, we can conclude that the current divergence is suggesting a change in the market environment.

If we use these tests to answer the original question of “How much deeper can we expect this pullback to go?”, we could see a pullback as deep as another -15% from Friday’s close. Barring a deep correction, I am looking for another -3.5% to -5% from Friday’s close.

***Update***

I changed the buy rules to allow an $NDX 5 day ROC < -1.0%. This change increased the number of occurrences to 61 and the number of trades held the full 50 days to 27.

Most importantly, not requiring the $NDX to have fallen more than -1.5% improves performance.

With the $NDX 5 day ROC at -1.61%, we should be cautious here. It appears the current environment may favor a steep pullback.

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