QQQ: Trading Legend Tom DeMark Sees NASDAQ 100 Nearing Exhaustion, And We Agree

The creator of DeMark indicators, Tom DeMark, is a legend among traders. His methods are recognized by the CMT Association for consistently identifying when price trends are nearing exhaustion. Tom DeMark now says that the NASDAQ 100 is appearing to become exhausted.

This technical indication appears to be at odds with a myriad of other technical indicators including a significant breakout and higher high on the Invesco QQQ Trust ETF NASDAQ:QQQ. Price is above daily moving averages that are all in an uptrend. It would appear that a new bull market has begun.

It is our belief, however, that strength in the NASDAQ is due to several acute and temporary factors. The longer term fundamental support for the NASDAQ is less rosy. We think this warrants caution and is the reason why we are underweight technology at the moment.

Take Your Breadth Away

The first reason for our skepticism of this rally in equity markets is the lack of market breadth. While the QQQ has gained over 26% YTD, the S&P 500 equal weighted ETF (RSP) is nearly flat. This is an indication of a lack of breadth in the market and likelihood that a few stocks are essentially carrying the market.

The number of net new lows for the NASDAQ composite over the prior year and a half has been the highest since 2008. The NASDAQ started a new bull market in 2009 as the market shifted to net new highs.

Most of the year to date returns for the S&P 500 and QQQ comes from a few of the largest technology stocks. The combination of AAPL, MSFT, and NVDA has outperformed the QQQ over 2:1.

While 67% of NASDAQ stocks trade below their 200 day moving averages, the largest names in tech including META, GOOG, and TSLA are up 32-111% year to date!

Year to date, Apple, Microsoft, Nvidia, Alphabet, and Meta have accounted for over 80% of the S&P 500’s returns. These individuals have contributed to an even greater share the NASDAQ’s returns.

One of the contributing factors to this lack of breadth is the momentum behind recent developments in AI technology. Among these top performing companies are those that the market expects will benefit the most from AI including MSFT and NVDA. Seeking Alpha reports that AI has been mentioned in recent earnings calls over 1,072 times. Google Trends data shows that searches for the term “ai” have absolutely exploded since February 2023 growing from a relative search interest level of 13 to 100 in three months.

NVDA, the largest contributor to the NASDAQ’s gains, has traded up to a price to sales ratio of 28x. This kind of valuation is difficult to imagine. The market expects the company to grow so quickly that today’s price is worth 28 years of today’s revenue, not profit. We detect excessive exuberance related to the positive outlook of ai technology.

Economic Conditions

Another reason for these concentrated returns is the flow of capital to the strongest names. Investors face many uncertainties in today’s market with economic indicators turning towards contraction while the future of rates remains unclear as the Federal Reserve continued to hike rates at the last meeting and inflation remains stubborn. Many market participants value the perceived safety of large cap names with strong moats.

To compound the issue, the U.S. Federal debt ceiling is preventing the U.S. Treasury from issuing new debt, which is temporarily removing a place for investors to park cash and dissuading investors from buying short duration T-bills for fear of a default in payments, as evidenced by the volatility recently experienced by 1-month T-bills. From the perspective of many investors, stalwart companies like Apple and Amazon now have stronger balance sheets than the U.S. government, and with good reason. This helps to push earnings yields below T-bill rates. AAPL, for example, now trades at a 3.45% earnings yield which is 157 basis points below the 1-year Treasury rate, which should be safe from the debt ceiling issues for now. The earnings yield for NVDA trades at a staggering 430 basis points below the 1 year Treasury rate.

Bulls will respond, “Yeah, but growth” to justify illogical risk premium on these large cap names. It’s true, enough growth can justify the negative premium, if growth delivers. Right now, the bar is set high. The 10 year real yield, inverted in black in the chart below, sits at a positive 1.47%. Price changes for the QQQ is negatively correlated with real yields as it effects risk premium. When rates become more attractive, the future cash flows for high growth stocks are discounted. Since February, the QQQ and real yields have become disconnected. That’s right, “ai February.” Real yields suggest that QQQ would be more fairly priced around $280.

Macroeconomic conditions continue to point towards weakness that would be expected to impact GDP and earnings. Year to date, more than 236 U.S. corporations have filed for bankruptcy, the highest since 2010 and its only May. The Conference Board Leading Economic Indicators declined again in April by 0.6%. The index is at levels that have been associated with all recent recessions. The Philly Fed Manufacturing index is now at -31.3 which has consistently correlated with recession. The NY State Manufacturing index is similar at -31.8. The Conference Board Leading Index was down again this month by 0.6%, the 13th consecutive monthly decline.

If the rug gets pulled under growth investors will not be so keen to pay for equities at negative risk premium. Small caps, represented by IWM, and the base metal copper are more sensitive to economic conditions than the NASDAQ. Both are demonstrating relative weakness compared to the QQQ.

What Can Happen

The Treasury General Account, which has been adding liquidity to markets due to the debt ceiling limit, has now reached $57 billion. This is $83 billion less than its balance a week ago. This source of liquidity is nearly exhausted and due to reverse into a liquidity draw in the coming weeks. This is the lowest level for the TGA since December 2021, when the NASDAQ recorded its last major peak.

Some of stability in equities is due to short covering that has resulted from this strong momentum in large caps. Short interest data from NASDAQ demonstrates that short interest has been declining for some stocks, like NVDA, while it has been increasing for others like MSFT. Short interest on QQQ has declined by 14% since February.

Click to enlarge

On the downside, we see the following catalysts occurring for the rest of the year for the NASDAQ:

1. Liquidity from the TGA reverses as the debt ceiling is raised.
2. Short covering exhausts and removes buyers from the market.
3. The excitement around ai subsides to more realistic expectations.
4. Earnings growth for large cap companies is revised lower.
5. Risk premium begins to normalize.
6. Sentiment shifts from bullish to bearish.

A year ago, the Fear and Greed index by CNN Business was in the “extreme fear” category. For the last month, the index has been indicating “greed.” We have become witness to this shift in sentiment as our social media presence has been flooded by overwhelmingly bullish commentary that has become combative towards known bears. Bulls point to the positive technicals and proclaim that a new bull market must have begun.

Anything is possible, and it may very well be a new bull market. No one will know without hindsight. However, we believe that the data reviewed here shows that this is likely a bear market rally fueled by enthusiasm, acute financial conditions, and short covering.

It’s difficult to determine what may happen next. The market is not required to be rational, or rather, to do what we perceive to be rational. This applies both ways. We do see many similarities between markets today and those of the period between 2000-2002 and have written about this subject many times before. Using 2000-2002 as an example, and not a direct comparison, we can learn a few lessons.

First, after the NASDAQ peaked in 2000, it dropped 40% before rallying 40% nearly reaching the 61.8 Fibonacci retracement. The Fed had paused rate hikes before the bear market rally and started to cut rates shortly after the rally double topped and headed down. The NASDAQ declined 74% from that bear market rally peak before bottoming.

Today, the NASDAQ peaked in 2021 and fell 37%. Falling 37% is a warning for investors that something significant has changed. The market has since rallied 24% and is approaching the 0.5 Fibonacci retracement. Clearly, there is more room for the market to go before violating the behavior of the 2000-2002 NASDAQ. In addition, the Fed has yet to pause, although the market is pricing in such a pause with futures markets pricing in an 81% chance that the Fed will pause next month.

Summary

None of this is to say that the market is imminent to fall. There is plenty of room left for this market and nothing about it must be logical. This is one of the reasons why we’re not keen to short the NASDAQ here.

Market sentiment is strong while a few select large cap names hold up the S&P and NASDAQ, especially those that have exposure to ai. The positive catalysts are becoming fewer and the negative catalysts are growing. Tom DeMark believes the NASDAQ 100 is exhibiting signs of exhaustion. We see signs of exhaustion in the TGA. We remain skeptical that this is a new bull market. New bull markets should be born of breadth after monetary easing has begun, not before.