It’s been a rough start for the tech heavy NASDAQ in 2022. The media fan favorite benchmark has been on fire in recent years. After gaining over 40% in 2020 despite the outbreak of the COVID crisis, the NASDAQ tacked on another 20% in 2021. And the index was no slouch in the late 2010s, having advanced by more than 65% from 2017 to 2019. So while the New Year is still very young, it is still notable that the NASDAQ Composite Index is off by nearly 5% so far in 2022. Is this stumble out of the gates a fleeting breather, or is it an early sign of what may come for the rest of 2022?
It ain’t cool being no tech turkey so close to Thanksgiving. It should be noted at the outset that the recent NASDAQ weakness is not necessarily a 2022 thing. Instead, the slide in the NASDAQ dates back a couple of months to around Thanksgiving. It was right before Thanksgiving that we saw the NASDAQ grind out two successive new all-time highs. But since November 22, the index has been in a marginally downward sloping trading channel with a successive series of lower highs and lower lows.
The initial bullish take on the chart above is the following. First of all, the NASDAQ has been a rock star for several years now, so the fact that it has been drifting lower for the last several weeks is a healthy and long overdue period of consolidation if nothing else. And even if the NASDAQ is in a marginal downtrend for the time being, it has just bounced off the bottom of this trading channel and has the potential to rally higher to the 15,300 to 15,600 range over the coming weeks even within this trading range.
NASDAQ uptrend still very much intact. If one zooms out and examines a longer-term view of the NASDAQ, this would provide further support to a still optimistic view on the tech heavy index. For once the NASDAQ broke out above long-term uptrend resistance in the summer of 2020 in the wake of the COVID outbreak, it has been off to the races to the upside since. These are very constructive points in support of the Composite Index.
That pesky mean regression thing. This leads us to our first problem confronting the NASDAQ in general and the tech sector in particular (more on this in a minute) as we begin making our way through 2022. Note in the chart above how the NASDAQ kept hitting the upward sloping blue line from 2018 to 2020. Although it deviated meaningfully to the downside over the period from 2018 through the first half of 2020, the NASDAQ would eventually rally and hit this line. And once it broke out above this line in mid-2020, it still came back down to hit it twice before surging higher starting in November 2020. While this surge to the upside has been fantastic so far, it cannot be ignored that the NASDAQ is now running well above its long-term trendline.
Why does this matter? Because the NASDAQ could fall by -17% from its current price at 14893 and -23% from its November 2020 all-time highs and its uptrend would still be fully intact with the pullback representing nothing more than what should be considered a natural regression to the mean.
If you are allocated to the NASDAQ or heavily weighted to tech, are you prepared to take such a downside move in stride? This is a particularly important consideration today given that it is extremely unlikely that the Fed will rush to save stocks on the next downturn given their recent 180-degree shift toward battling inflation head on.
Recent technical developments add to the concern. If we zoom back in to examine the various technical support levels for the NASDAQ, we see an index that may be in the process of slowly breaking down. In the chart above, we see how the NASDAQ first bounced higher off of its 100-day moving average (orange line) support on four separate occasions from September 2020 to March 2021. We then see how the index bounced off the next major support level in its 150-day moving average (purple line) on four different instances from May to December 2021. And since the start of 2022, the NASDAQ found resistance at its 100-day moving average for the first time in the current cycle and is now relying on support at its 200-day moving average (red line).
A technical battle is now joined. Holding the 200-day moving average support will be key for the NASDAQ as we enter the upcoming trading week. Unfortunately, this may not be an easy task, as a shorter-term uptrend line that was first broken by the NASDAQ at the start of 2022 is now looming as resistance. If the NASDAQ can push decisively back above 15,250 in the coming week or two, then all will be well and the short-term uptrend will remain intact. But if the NASDAQ gets pushed back to the downside at this trendline resistance and ultimately breaks below its 200-day moving average, A fairly big air pocket lies below that could see the benchmark index quickly drop another -10% before it finds support at its ultra long-term 400-day moving average.
A troubling narrowing of breadth. Adding to the concerns for the tech heavy NASDAQ is an issue that has been building since last summer. The percentage of stocks in the NASDAQ Composite Index trading above their respective 200-day moving averages has steadily compressed meaningfully from nearly 90% in July to just over 50% today. This is a particularly problematic underlying condition, as it implies that fewer and fewer stocks are carrying the weight of lifting the NASDAQ ever higher. If these remaining stocks start to falter in their own right, eventually the index itself starts to break down. Such narrowing of breadth like we see in the chart below commonly foreshadow an eventual correction in price.
What about the fundamentals? At this point, some of you may be casting scorn for my primary focus on the technicals. Will we be reading entrails next, you might be thinking? While technical analysis is a powerful tool in that it is the graphical representation of statistical information that enables investors to visualize behavioral patterns across capital markets, I respect the fact that it is not for everyone. As for my own process, while technical analysis provides useful information, particularly when it comes to identifying specific target entry and exit prices for selected securities, in the end an investment thesis must be supported by fundamental justification. So let’s examine the fundamentals.
Extraordinarily concentrated. The magnitude of the concentrated weighting to a select few stocks in the NASDAQ Composite is striking. Consider the following fact and let it wash over a bit. The NASDAQ consists of over 3,000 publicly traded companies, yet a select group of 10 stocks out of this 3,000 make up over 50% of the entire index weighting (52.5% to be exact). Who the heck needs a FAANG (or PTFAAAMNG if you will) ETF when you effectively get the same thing with the QQQ that’s supposed to be representative of what we know as a major market benchmark. After all, the NASDAQ gets mentioned with the Dow Jones Industrial Average in the mainstream news media a heck of a lot more than the S&P 500 (the fact that numerous mainstream news outlets will quote the Dow and the NASDAQ and not the S&P 500 when reporting on the markets is a nit that drives me nuts, but I digress).
Why does this matter? For the same reason that the declining breadth mentioned above is an issue. With just ten stocks making up over 50% of the entire NASDAQ Composite (including just two stocks that make up more than 20% of the benchmark!), this means that if any one of these stocks start to falter, it will go a long way in dragging down the entire index with it.
Nose bleed valuations. So what of these ten stocks? How much should we be concerned. First, the following is the list of these ten stocks and their respective weight in the NASDAQ Composite Index, virtually all of which either come directly from the Information Technology sector, were former members of the tech sector until being moved to the Communications sector a few years back, or are effectively tech stocks in Consumer Discretionary clothing.
Apple (AAPL) 10.93%
Microsoft (MSFT) 9.91%
Amazon (AMZN) 7.78%
Alphabet (ne Google) (GOOG) (GOOGL) 7.75%
Tesla (TSLA) 4.50%
Meta Platforms (ne Facebook) (FB) 3.78%
Nvidia (NVDA) 3.68%
PayPal (PYPL) 2.18%
Adobe (ADBE) 1.95%
An impressive list of stocks that have scored some tremendous price gains in recent years. But what about current valuations from a fundamental perspective? These ten stocks currently trade on a weighted average basis at 51.8 times earnings. This is an extraordinarily expensive collective valuation, particularly given the already massive size of many of these companies.
Viewed differently, these stocks are currently trading with an earnings yield of 1.93%. With the 10-year U.S. Treasury yield currently at 1.78%, this implies that investors are receiving a premium of just 15 basis points for taking on the liquidity risk, default risk, and equity risk of owning these stocks. In other words, investors are banking on a heck of a lot of growth in these stocks going forward to justify their valuations. Maybe this will happen, but with the economy both reopening and slowing at a time of rising inflation when the Fed is gearing up to start raising interest rates soon, the latter of which has the potential to further squeeze this premium due to higher yields on 10-year U.S. Treasuries along the way, this will be an increasingly high hurdle to clear in the coming months.
Even if we adjust the above list by eliminating the high P/Es that come with Amazon and Tesla, these stocks are still trading at a lofty 34.0 times earnings, which translates to a meager earnings yield of 2.94%. If Treasury yields end up rising as many are predicting, this premium would also get squeezed away quickly.
Bottom line. The NASDAQ and the technology sector have enjoyed a fantastic run over the last many years. While these upside gains may continue into 2022, the outlook for the tech heavy NASDAQ is looking increasingly challenging from both a technical and fundamental perspective. Recent deterioration in the NASDAQ can be traced back to the second half of last year, and investors will be best served to watch developments closely in the coming weeks. This includes watching for critical advances to reclaim recently broken key support levels.
Conversely, if we continue to see deterioration in the NASDAQ over the coming week or two, the probability begins to rise considerably for a further short-term, double-digit correction from current levels that would represent nothing more than a regression to the mean within a long-term uptrend.
Thus, keep a close eye on the NASDAQ in the coming weeks, as the outcome has important implications not only for the tech sector, but also the broader market and the sustainability of the post COVID bull run.
Trouble For Technology – Seeking Alpha