Do Large Cap ETFs Signal Trouble Ahead? SPDR Dow Jones Industrial Average ETF, SPDR S&P 500 ETF Trust

new etfsEric Dutram: All current discussion about stocks centers on whether stocks can continue their climb upwards. While there have been countless small issues tugging at the market, little has happened to change the positive sentiment overall, leaving bulls firmly in charge (see Three Tech ETFs Still Going Strong).

While the major U.S stock indexes have kick started 2013 making multi year highs, the biggest question still remains if they can sustain these levels or surge even higher from here onwards. And if yes, what fundamental drivers can cause them to do so?

Although the economy witnessed negative GDP growth this latest quarter, it was more on account of an aftermath of Superstorm Sandy, and some accounting tricks, rather than any other factors. In fact, a surprisingly better-than-expected earnings season has driven the domestic stock markets high this time.

However, viewing this fact in isolation will not be enough to address the issue. As it has become widely known as of late, earnings of U.S.-based companies are increasingly dependent on overseas markets.

In this regard it is prudent to mention China, which has overcome the possibility of a hard landing and is on its way to recovery (see Can Solar ETFs Continue Their Bull Run?).

European nations are also worth mentioning, s they are the largest trade partners of the U.S. and they have been relatively stable over the last few months thanks to the efforts of the ECB. These factors have been largely responsible for the better-than-expected earnings picture.

While this has definitely helped the markets to sustain these high levels, only time can tell if such optimism from the earnings front is already discounted by the markets.

Whatever be the case, these factors will have an effect only in the near-to-mid-term. However considering the long term scenario, some interesting charts definitely have a lot of messages to convey.

The above long term price chart (10 years) is of the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) which hints at a textbook double top pattern. The unadjusted ETF prices have been used as a proxy for the actual index i.e. the Dow Jones Industrial Average. While it is still early days to call it tops, the ETF (and Index) remains overheated nevertheless.

The Relative Strength Index reading of 66.03 signifies that the ETF has been overbought. In fact, it has been hovering near the overbought territory for a very long time. This chart pattern definitely points towards an eminent correction.

Some may argue that the Dow is not a true and fair indicator of the large cap sentiment primarily due to its small sample size. However, the long term price chart of the SPDR S&P 500 ETF Trust (NYSEARCA:SPY), representing the S&P 500 also exhibits somewhat similar characteristics (unadjusted).

A double top (without a bullish breakout just yet) and an overbought state is pretty much the name of the game for the S&P 500 as well. However, the market breadth poses reassuring pictures regarding the uptrend of the broader markets.

Still, in this regard it is prudent to understand that for a market trend to sustain the support of the equity market breadth is of prime importance. It signifies the strength of the trend.

In this case, the market breadth surely hints towards the positive side as indicated by the “other 2400 stocks”.

The following two charts are of the iShares Russell 2000 ETF (NYSEARCA:IWM) and the SPDR S&P MidCap 400 ETF (NYSEARCA:MDY) representing the small and mid cap space of the U.S. equity market breadth i.e. the ‘other 2400 stocks.’

It is evident from the charts that the recent rally is not restricted to the large cap space. In fact, the mid and small caps have fueled this rally even more.

Therefore the strength of this rally has been quite positive. And it is this strength that has enabled these mid and small cap ETFs (representing the broader indexes) to carry this momentum forward (read 3 ETFs at the Heart of The Recent Rally).

In fact these two ETFs have already broken through the resistance suggesting that momentum is certainly favoring the market breadth. While this is clearly great news for their large cap counterparts as it eliminates the possibility of the double top as discussed earlier, it brings us to two key questions:

Will the market breadth be able to sustain this? And if yes, what will cause them to do so?

While the answers are still unclear at this point in time, it is very likely that the market will carry this momentum forward at least in the near term. However, a slightly longer term look is less rosy, as fundamental drivers—like GDP and sluggish job growth—could be troublesome to the market if the rally sputters.

This article is brought to you courtesy of Eric Dutram From Zacks.

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