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Caution: The US stock market is out of balance
John J. Hardy
Chief Macro Strategist
Résumé: The US stock market is showing signs of near-term speculative excess, as traders and investors pile into the high momentum trades while the broader market is suffering. These kinds of divergences can precede ugly bouts of market volatility.
The US stock market is showing obvious signs of speculative extremes as specific high-momentum stocks and sectors have ripped higher even as the broader market is showing signs of increasingly feeble price action. The action in key names is so strong that nothing appears amiss if you only look at the mega-cap heavy Nasdaq 100 index and even the broader S&P 500 index, both of which have posted new all-time highs this week. The Nasdaq 100 is up an incredible 34% this year, with the S&P 500 up 27%.
But widen the focus and move out of the mega-cap space and the average stock is actually quite weak. A headline yesterday noted that the Dow Jones Industrial average just hits its worst string of daily losses since 2018. Many rightly criticize the Dow Jones index as an irrelevant relic of the past: its component Sherwin Williams, basically a paint manufacturer, currently carries a weight within that index that is more than two-and-a-half times that of fellow Dow component Nvidia. But other broader market measures like the “equal-weight S&P500 index”, which equally weights all components rather than weighting them by market cap, was down as of the close yesterday by 3.7% since the all-time high at on the last day of November. The Dow Jones Transport index, long considered an excellent leading gauge of the real economy, is down over 7% since its late November high.
Chart: The Nasdaq 100 Index versus the Equal-Weight S&P 500 Index
It’s rare to see the scale of divergence in a broader measure of the market like the Equal-Weight S&P 500 Index and the Nasdaq 100 Index. (There are ETFs that try to mimic the performance of the Equal Weight S&P 500 Index – just search “equal weight” on your Saxo platform in the Instrument Search.)
And then there is Nvidia itself: the superhero performer of the mega-cap and Magnificent 7 stocks of the Nasdaq 100 index this year is trundling along near two months lows at a time when the overall index is blasting to new all-time highs. When former leaders become laggards, one should take note.
Yes, some specific names have blasted higher on quite positive news recently. Take for example Broadcom’s 37% surge post-earnings this week that added over USD 400 billion to the value of the company, with enthusiasm in large part based on the strong growth in AI-linked product offerings. While that company reported real results and we can debate whether the level of enthusiasm is appropriate, developments elsewhere look a bit frothy and are pricing in years of good news in the space of weeks. Tesla is a notable example – flying higher in part on the hopes the Elon Musk has the political sway at Trump’s side to score a friendly federal-level regulatory environment for Tesla’s full-self-drive vehicles – which are not yet “fully” self-driving and as the company’s future “Cybercab” won’t hit production until 2026. Tesla’s top-line is expected to grow less than 20% in the coming year and profit growth is expected to rise only slightly better than 10%, and yet the stock price is up 84% since the US election in early November. Another example is the quartet of small quantum computing stocks recently linked to AI-hopes more than real results, which I profiled recently and are up several hundred percent in just weeks.
So what?
History shows us that huge divergences in market sectors can precede significant market volatility. One of the most dramatic examples of this was in the patterns that developed in 1999 and into early 2000, which led to the unwinding of the great Tech Bubble. A brief recap: starting in late October of 1999, the Nasdaq 100 launched a fresh rapid ascent that took it to dramatic new all-time highs, gaining over 12% in November and another 25% in December. In those two months, the equal-weight S&P 500 posted a loss in November and a solid gain in December, but at the time was still trading below it’s all time high from earlier in 1999. The peak in the Nasdaq 100 came in March 2000, over 80% above the October 1999 close. That peak was not exceeded until late 2016. The equal-weight S&P 500 peak came much later in May of 2001 and after a bear market was exceeded again already in late 2003.
This is not to say that history will repeat, as market conditions in different eras are never identical. But with the increasingly imbalanced moves like the ones we have seen of late, it could be worth considering a bit of portfolio rebalancing and a general trimming of position in cases where one or two or even a handful of positions are all moving in synch and dominating a portfolio. Momentum trading on the scale we have seen lately in the most intensely speculative spaces is destabilizing, especially when the broader market is faltering.
What could trigger a significant reversal of recent market developments? Hard to say, but we are coming up on a FOMC meeting tomorrow that could see a more hawkish stance from Fed Chair Powell as recent inflation measures have picked up. We also have the end of the year rolling into view with risk at the margin of portfolio rebalancing. Most importantly, we are just a few weeks from a Trump 2.0 administration that is set to bring potent policy moves that may or may not work as intended. Sure, the timing of my concern could be way off, but as a rule, the best times to strike a more cautious tone are when markets are semi-euphoric, just as the best times to worry are when everyone is down in the dumps.