Larry’s note: Welcome to Trading with Larry Benedict, the brand new free daily eletter, designed and written to help you make sense of today’s markets. I’m glad you can join us.
My name is Larry Benedict. I’ve been trading the markets for over 30 years. I got my start in 1984, working in the Chicago Board Options Exchange. From there, I moved on to manage my own $800 million hedge fund, where I had 20 profitable years in a row.
But these days, rather than just trading for billionaires, I spend a large part of my time helping regular investors make money from the markets. My goal with these essays is to give you insight on the most interesting areas of the market for traders right now. Let’s get right into it…
Good traders should be able to recognize and take advantage of correlations across the market.
Last month, we looked at the correlation between gold and silver.
However, that was just one example.
Correlations exist throughout all markets… Like between bonds and equities, or currencies and commodities.
The more you look, the more of these correlations you’ll find.
One of the lesser known, but very useful correlations is that between the Nasdaq and the S&P 500.
It’s something I look at all the time.
Quite frankly, I’m really surprised that more traders don’t look at it as well.
So, let’s take a look…
The chart shows the ratio between the Nasdaq and S&P 500 indexes going back five years.
When the blue line rises, that means the Nasdaq is outperforming (better than) the S&P 500. When the blue line falls, the Nasdaq is underperforming (worse than) the S&P 500.
From 2016 through the start of 2020 (‘A’ to ‘B’ on the chart), this ratio grew from 2.42 to 2.78. In other words, the Nasdaq outperformed the S&P 500 by 15% over that time.
Then, from January 2020 (‘B’) to the ratio’s peak in February this year (‘C’ on the chart), the ratio climbed from 2.78 to 3.58. That’s an increase of 29% – almost double that from A to B.
What’s more, that move from B to C took only 13 months. That’s less than one-third the time it took to go from A to B (which took 41 months).
That’s a very dramatic change in such a short time.
Of course, that could mean the Nasdaq was potentially running too hard and fast against the S&P 500 since the start of 2020.
But that’s why the current chart pattern looks really interesting to me…
On the chart, you’ll notice that the ratio (blue line) has traded sideways on either side of the peak (‘C’).
From July 2020 to December 2020, the blue line bounced along the 3.25 level.
Then, after peaking at C, the blue line fell just about all the way back to the same level (3.25) before trading sideways again.
This is what technical analysts refer to as a head-and-shoulders pattern. Essentially, the C is the head, and the sideways action on either side would be the shoulders (red lines on the chart).
Quite often, this pattern can indicate a major trend reversal.
In this case, that would be mean a change in trend from a bullish pattern to a bearish one. And, the Nasdaq could start to underperform the S&P 500.
So, what does that mean for traders?
If the S&P 500 falls, the Nasdaq falls further. In this scenario, I would likely short the Nasdaq instead of the S&P 500.
If the S&P 500 rallies, the Nasdaq rallies less. In this case, I would likely choose to go long the S&P 500 over the Nasdaq.
As with anything in the markets, though, there are no guarantees.
No technical indicator or analysis works 100% of the time.
However, as a trader, this kind of information is invaluable. By looking at correlations, it can help put you on the right side of the trade.
Editor, Trading With Larry Benedict
P.S. We’re excited to hear what you think of your new eletter, Trading With Larry Benedict. Let us know at [email protected].