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Nasdaq's Mo May Need Some Joe
By Harry Milling

Morningstar

NEW YORK — The Nasdaq Composite Index was back on the throne this week amid a near coup by value-oriented investors, which almost made the battered Dow Jones Industrial Average look like the new momentum king.

But is the momentum that lifted the Nasdaq index above 5,000 really back in full force?

The fundamentals for technology stocks, which dominate the Nasdaq Composite, continue to signal that the index should handily outperform the Dow and the Standard & Poor's 500 Index this year. The earnings growth of these companies will be more than double that of most other sectors this year, according First Call/Thomson Financial.

But I'm talking about whether momentum is becoming as strong a force as it once was in Nasdaq. In that case, who cares about the fundamentals of the tech sector? Momentum investors don't.

In John Murphy's definitive Technical Analysis of the Futures Markets, he identifies momentum as "the rate of change of prices as opposed to the actual price levels themselves." Momentum can thus be expressed numerically because it is derived by contrasting differences in price points.

To use Murphy's example, one can plot the momentum of an index or stock and use a period of X number of days as a benchmark.

If you choose a five-day period, you would subtract the current closing price from the settlement of five days ago, and do the same for the previous day, using the closing price from five days before that, and so on, until you have a momentum line.

If the closing prices are higher than those at the end of the previous period, this indicates upward momentum, and the results are positive figures. When the closing prices are below the previous figures, the results are negative.

Using this method of measurement, the Nasdaq Composite is definitely back in the black and showing upward momentum.

Rate of change can also be plotted by dividing a closing price by its closing price X days ago and multiplying it by 100.

Momentum Gets Sexier

That momentum explanation is a snoozer, I know, and frankly most momentum investors are not bothering with mechanics. They are simply jumping on the bandwagon of a rising stock, hoping that it will continue to rise.

However, if they had found out how to plot momentum, they could do more than just hope. Gauges of momentum called oscillators can help determine how much upward momentum is left. Like any indicator, they should be used within a varied matrix that helps determine a trading strategy.

An oscillator can help determine the degree to which a stock or an index has regained momentum. There are many oscillators, but the Relative Strength Index, or RSI, is a particularly popular one. It is partially determined by dividing an average number of positive settlements in a period with the negative settlements from the same time frame.

When the RSI number gets really high, it signals overbought conditions, and when it gets low, it reflects oversold conditions. The RSI was put on a scale of 0 to 100, and many use 70 as the cutoff for an overbought area and 30 for an oversold area.

Just How Strong Is Nasdaq's Momentum?

The Nasdaq Composite's 14-day RSI (a standard time period to use for this measure) stood at 59.90 as of Thursday's close versus 47.91 on March 15, when it closed 9.2% beneath its 5048.62 record. Thus, momentum is recovering, but the index is hardly overbought.

But will its momentum recover to previous levels as measured by the RSI?

The RSI-14 was 74.19 when the Nasdaq Composite hit its closing record; the index then declined almost 350 points over the next two sessions. But an index can be reflecting overbought or oversold conditions for weeks before it breaks out of its pattern.

If one relies strictly on the RSI-14 to explain the sell-off, then the reason for the sell-off lies in the pattern that the Nasdaq Composite's RSI has been following, not in the temporary overbought condition itself.

While the RSI-14 reflected an overbought 74.19 on the day of the record, momentum actually had been dying down. The RSI peak before the January sell-off was 86.76. Murphy points out that when an RSI peak does not surpass its previous peak, it may be a "top failure swing," possibly signaling the end of a trend. The nadir of the RSI has to be beneath the previous one, as well.

That's not the case for the most recent low point, however. At least not yet. The 14-day RSI during this past sell-off was 47.91 versus the low of 46.03 during the January sell-off.

On the other hand, the Dow's 14-day RSI stood at 66.16 as of Thursday's close, recovering from 25.69 hit during its recent correction — a much more dramatic recovery in momentum than the Nasdaq's.

While the Nasdaq index is regaining its momentum, the jury is still out on whether it can recover the strong momentum it had before. Until then, its reign as the momentum king may be on shaky ground.

Harry Milling is Morninstar.com's market commentator. He welcomes e-mail but cannot meet requests for customized portfolio advice. He can be reached at harry.milling@morningstar.com

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