For months the primary market theme has been narrow strength in a small group of mega-cap stocks that are benefiting from the development of artificial intelligence. Money has poured into these names, and because the indexes are capitalization-weighted, it has created the illusion of very strong market conditions.
The reality is that the majority of the market is still struggling with a bear market, but the indexes have been hiding it. Even worse, it has created a high level of bullish sentiment even though the vast majority of market participants are significantly lagging behind the performance of the Nasdaq Composite and Nasdaq 100.
It is obvious that this two-tiered market action can't continue forever. At some point, the gap between the mega-cap tech names and everything else has to start to close. That can happen in a variety of ways, but it will happen sooner or later.
Over the last few days, the process of closing the gap has started. Small-caps have produced significant outperformance. The Russell 2000 has jumped nearly 7% over the last four days, while the Nasdaq 100 has declined about 0.8%.
This rotational action is bumpy and inconsistent, but it makes for a much healthier market because there are far more stocks participating now. There is an increased focus on picking stocks that might have positive technical setups or fundamentals rather than just piling into a small group of big-cap names that are advertised as AI havens.
The big question now is how this transition continues to develop. Have big-cap technology names topped out? Is that rally over? Will dip buyers provide support, or will selling pressure accelerate? Can small-caps manage to produce sustained momentum as they close the performance gap, or will they cool off as economic issues come into focus again?
The Fed will meet in one week and there is still an intense debate over whether a recession will occur. Concerns about inflation are cooling, but some economists believe that it will stay sticky and keep the Fed hawkish for longer than the market expects.
The market is at an important juncture right now as the performance gap is creating some pressure. For now, the best opportunities lie in the lagging names, but economic conditions could easily kill any small-cap momentum.
We have a flat start on tap here on Thursday morning with a little rebound in some of the mega-cap tech names.
