Global Troubles Spell Nasdaq Losses

Equity benchmarks across the globe have felt the China reverberation as commodity deflation suddenly turns to commodity crisis. For stocks, this has been a reality check with many benchmarks trending nearer to the August lows with each passing session. After the spectacular rout that ensued before China got a grip on its own fledging capital markets, it is unsurprising that the same questions about the global economy are coming back to the forefront as risk aversion begins to grip markets and investors seek out safe havens. The most recent bout of tumult has seen equity valuations sink with the Nasdaq Composite showing an emerging bearish bias thanks in large part to the appearance of the death cross technical formation. With crisis conditions back on the horizon and the situation in China unlikely to abate soon, losses in equity markets might still be in their infancy.

The Fundamental Picture

The Nasdaq Composite is largely a technology weighted index with over 5000 companies as constituents of the index. The Composite is weighted based on the market capitalization of the component companies, the single largest component being Apple which accounts for well over 10% of the index. At present levels, the index is very sensitive to the world’s most valuable company, with movements in Apple translating often to momentum in the index. Other famous components include Microsoft, which represents the second largest company by market capitalization in the Composite. Technology valuations in particular have come under fire over the course of the last year with Federal Reserve Chairwoman Janet Yellen complaining about the “stretched valuations.” The latest retreat in the index highlights the growing chorus of bearish calls from equity analysts and revisions lower in the earnings outlook.

In general, the Nasdaq Composite has a multiples valuation that is only eclipsed by the Russell 2000 which has more components when compared to the more narrow Dow Jones and S&P 500 indices. Currently, the trailing twelve month price-to-earnings ratio for the Nasdaq Composite is 25.53. To put this in a historical perspective, the average price-to-earnings ratio for the S&P 500 since the index was founded is 15.55, below the current 18.90 multiple. With this in mind, the Nasdaq Composite might see its very own over-extended multiple retreat after climbing above 28 back in May. The correction in the valuation however is likely just beginning as the index faces a host of challenges to the outlook. While 1-year performance for the index is modestly positive at 0.17%, year-to-date the index has lost -4.70% with the Nasdaq Composite giving up -8.97% in the last three months alone.  If the valuation multiple were to revert to more historical levels, current price action might only signal the beginning of a weak outlook for the Nasdaq Composite.

The Technical Take

Fundamentally, there are many reasons the Nasdaq Composite might be dragged lower including the weak global trade outlook and moreover the retreat in technology valuations. Although technology managed to weather the last financial crisis with relative ease, slower global PC shipments and another retrenchment in capital expenditure spending might see technology as an early loser. Aside from the fundamental picture, the technical picture confirms the bearish bias with a multitude of indicators screaming sell. The most prominent of these is the recently formed death cross formation in the Nasdaq Composite. The pattern which is a confluence of the 50-day moving average crossing the 200-day moving average to the downside is notorious for its unusually strong signal.  One of the more famous recent examples is gold prices which saw the pattern emerge back in 2013 before a long stream of losses unfolded, bringing the precious metal into a bear market. 

The development of the “death cross” in the Nasdaq Composite with both moving averages turning negative is an equally ominous sign from a technical perspective.  Not only is the Composite trading well below both averages, but the equity benchmark has fallen below key support levels and is not facing the critical low from the August equity carnage at 4292.  A fall below this level could mark a longer-term shift in the trend which could indicate a reversal downwards.  With this is mind, Put positions targeting 4292 should be initiated over the more medium-term by simply applying the combination of fundamental and technical factors.  However, on the upside, should key resistance at 4962 be overcome, it could mean the current signal has broken down and the technical pullback has ended, necessitating Call positions targeting 5232 on the upside.  Nevertheless, considering the bias lower, the longer-term target for Put positions is 4120.

Conclusion

Between a quick review of valuation multiples of one globes most valuable equity benchmarks, menacing economic backdrop, and ill-omened technical signs, the Nasdaq Composite is likely to face a difficult road ahead.  With no expected near-term pickup in global trade and more challenging outlook for technology companies as investors brace for another round of turmoil, the correction in the Nasdaq Composite could be deeper and sharper than expected.  With the key 4292 level under the threat of a retest, a break below this level could foment an expanded unwind in equity exposure, denting the outlook even further for the Composite index.  Put positions are preferable considering the circumstances, but should the Nasdaq Composite muster a rally above 4962, it could mean another shot at recent highs necessitating initiation of Call positions.  Bearing in the mind the risks though, caution is merited with the potential for the Index to slip into a bear market rising with each passing session.