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New high, new buy

Nasdaq bursts higher

The stock market is taking all this very well indeed. Going by the indices' action, you'd have thought it was all done and dusted. Since its lows of last week, the Nasdaq has rampaged higher, touching a new bull-market high on Tuesday, 15 October. The last time that the tech index was at such lofty levels was in November 2000. The S&P 500 and our own FTSE 250 have also posted tidy gains. While I was bullish ahead of these moves, even I have been surprised by the markets' strength.

Mid-caps surge

Barclays Capital suggests that the ongoing political wrangling could see the start of the withdrawal of the Fed's money-printing efforts put off until 2014. I would have to see that as a good thing. In my view, this bull market is being driven higher by ample liquidity first and foremost. Cutting the inflow of newly minted cash is likely to be harmful to equities, in my view, particularly in the overvalued US market.

Today's breadth divergence

While the S&P 500 is only slightly below its all-time record closing high, the number of stocks on the NYSE making fresh highs for the year is well below its peak of earlier this year. I stumbled on this fact thanks to the brilliant Tom McClellan of the McClellan Market report (www.mcoscillator.com). The latest peak in the NYSE New Highs index was back on 15 May. Today's reading is only about one-third of that level.

Past breadth divergences

According to Tom, this means trouble ahead. He points to previous divergences, that is, times when the S&P was making fresh highs but the number of NYSE stocks at new highs was not. Those he picks out are that of 2007, which ended up in a meltdown for equities, and also 2011, where we got a smaller, but still scary bear market in US stocks.

"The magnitude of the divergence we are seeing now in the number of new highs suggest that the market is due for more than just a pullback to its uptrend line," says Tom.

The logic here is the same as that behind the advance-decline line, which I recently discussed. 'New highs' is a measure of market breadth. When an index is making new highs, lots of members ought to be doing the same. If they aren't, it's a sign that the bull market is being driven by fewer stocks. In the case of the advance-decline line, divergences often foretell a significant reversal in the uptrend.

I have NYSE new highs data going back to 1990. Scanning through those episodes where the market has been at new highs but new stocks making annual highs were in the same state as they are today, I find that the worst fall on average suffered three and six months thereafter is 6.1 and 7.2 per cent. Corrections of greater than 10 per cent are the exception, not the rule. This isn't a worry from where I'm standing therefore.