Will NASDAQ weakness unravel the bull?

Preface: Explaining our market timing models 

The latest signals of each model are as follows:

Call the Market Police! The NASDAQ Composite has fallen for two consecutive weeks and violated a rising trend line. It seems that the AI-fueled party is over.
 

The key question is whether this pullback unravels the equity bull case.
 

The AI party is over

The accompanying chart tells the story of an AI-fueled party for NASDAQ stocks. The relative performance of the NASDAQ 100 (black line) had historically been inversely correlated with the 10-year Treasury yield (red dotted line). That makes sense as NASDAQ stocks, which have growth characteristics, are high-duration vehicles and therefore more sensitive to interest rate changes. The relationship diverged in early 2023 when the market was gripped by an AI frenzy. In addition, the relative performance of the NASDAQ 100 was also correlated to the relative performance of EM Internet and eCommerce stocks (EMQQ, bottom panel). EMQQ similarly did not participate in the AI-fueled rally in 2023. More recently, the NASDAQ 100 violated a key relative support level, indicating probable further weakness ahead.
 

Semiconductor stocks, which led the AI charge to the upside, have now violated an important relative support level.
 

This analysis of the NASDAQ 100 tells the story of breadth deterioration. The bottom two panels show that NASDAQ 100 relative breadth indicators have been corroding. To be sure, the relative percentage of stocks bullish on P&F chart has reached oversold levels, though the differences in percentages in stocks above their 50 dma have not.
 

A rolling correction

The weakness in NASDAQ and AI-related stocks doesn’t necessarily mean that the bears have control of the tape. The top five sectors of the S&P 500 comprise 73% of index weight, and it would be difficult for the index to meaningfully rally or decline without the participation of a majority. An analysis of the relative performance of these sectors shows uneven and un-synchronized relative strength. The growth sectors, technology, communication services and consumer discretionary, of which nearly half is made up of heavyweight growth stocks Amazon and Tesla, are either flat to down against the S&P 500. By contrast, the other two sectors, healthcare and financials, are starting to exhibit improvements in relative strength.
 

This looks like a rolling correction where one group weakens and others rise to take up the baton of fresh leadership.
 

The growth and value divide is more evident as we go down market cap bands. While large-cap growth and value relative performance have stalled since June, value outperformance can be seen more clearly in mid-caps and very clearly in small caps.
 

These results are supportive of the rolling correction thesis. In addition, the relative performance of defensive sectors is not strong, indicating that the bears haven’t taken control of the tape.
 

Bearish impulse stalling

Sentiment has normalized from bullish extremes, which I interpret as bearish momentum is stalling. The latest AAII weekly survey shows that %Bears at historically low levels, though the bull-bear spread remains elevated.
 

Similarly, the 10 dma of the CBOE put/call ratio has nearly returned to its 200 dma.
 

However, that doesn’t mean that stocks are ready to bottom. None of the four components of my Bottom Spotting Model have flashed buy signals. The four components are:

1. VIX Index above its upper Bollinger Band.
2. An inversion of the term structure of the VIX.
3. The NYSE McClellan Oscillator (NYMO) falls below -50, which is an oversold condition.
4. TRIN above 2, indicating price-insensitive selling, or a “margin clerk” liquidation.

Historically, the market has shown good risk/reward long entry points whenever at least two of the components have flashed buy signals.
 

In summary, the weakness of large-cap NASDAQ growth stocks, which comprise over 40% of S&P 500, is a drag on the S&P 500. However, the market appears to be undergoing a rolling correction, which should limit severe downside risk for stock prices. Even though the market appears oversold in the short run, the corrective period is probably incomplete and investors face further downside risk. Initial S&P 500 support can be found at the 50 dma at about 4440 and secondary support at about 4200.