Yesterday, I shared a ratio chart comparing Germany and Spain. Today, let’s look at two U.S. equity indices: the Dow Jones Industrial Average and the Nasdaq.

These two indices behave differently from one another. By comparing the two, I can gauge whether investors are being driven by fear or greed.

The Nasdaq typically performs stronger in bull markets than the Dow. That’s because Nasdaq stocks are typically tech-oriented or growth stocks. They carry the promise of outsized returns so investors pile into these when they feel confident. When I see the Nasdaq doing better than the Dow, I know investor greed is driving the market.

The Dow Jones Industrial Average, on the other hand, does better than the Nasdaq in down markets. Some of the most stable corporate giants – think Johnson & Johnson, General Electric and McDonalds – make up the Dow. When investors become cautious, or defensive, they often opt for a stable Dow stock in lieu of something flashier. These investors want to keep their money in the market, but don’t want the volatility of the Nasdaq. When I see this happening, I know fear is driving investor actions.

With that in mind, let’s look at this chart. The Nasdaq (QQQ) in the green line on the top, the Dow (DIA) is the orange line in the middle and a ratio of the two (QQQ / DIA) is the yellow line in the bottom pane:

See larger image

There are a few things to make note of here…

First, the recent stock market correction chopped 8.8% off the S&P 500. During this time, the QQQ/DIA ratio declined, showing the Dow held up relatively better than the Nasdaq. Investors were scared so they kept their money in the “safer” Dow. This is textbook for how I’d expect these two markets to react to a meaningful correction.

This is the second correction we’ve seen in 2012. The last came between April and June. In that instance, the correction ended when the QQQ/DIA ratio fell to 0.5, which I’ve highlighted for you with a blue line.

Interestingly, the most recent correction ended (for now at least) on November 16 when the QQQ/DIA fell again to this exact same level, 0.5. Since then the ratio has turned up again, showing the Nasdaq’s strength during the bounce higher.

The question now is… will the rally last?

When I look back to last year this time, the market was behaving much the same as it is now. In 2011, the Nasdaq lost nearly 12% going into Thanksgiving. The market recovered in early December and then rocketed higher through the first three months of the new year. All told, the Nasdaq (QQQ) gained 30% by April 2012.

There’s no way to say for sure whether or not the rally will last. But if it does, and if we ring in the new year like we rang in the last, look for some big gains in Nasdaq stocks… these will shooter higher than Dow stocks.

I’m keeping a close eye on this indicator as it’s one of the best gauges of market sentiment I’ve found.

If you haven’t done so already read the Survive & Prosper issue on “Just Because Everyone Is Doing it Now… Doesn’t Mean It’s Rational.



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Adam O'Dell
Adam O'Dell has one purpose in mind: to find and bring to subscribers investment opportunities that return the maximum profit with the minimum risk. Adam has worked as a Prop Trader for a spot Forex firm. While there, he learned the fundamentals of trading in the world’s largest market. He excelled at trading the volatile currency markets by seeking out low-risk entry points for trades with high profit potential. An MBA graduate and Affiliate Member of the Market Technicians Association, Adam is a lifelong student of the markets. He is editor of our hugely successful trading service, Cycle 9 Alert.