Momentum in the NASDAQ 100: Green Light for the Summer Rally

Includes: QQQ, XLK
by: Alan Brochstein, CFA

As I shared on my private blog on Friday, the market should have been crushed on the very disappointing news regarding employment. Rather than fade the elevated levels after the rally of the past couple of weeks, investors apparently used the bad news to add to positions, as the lows were set 90 minutes into the day and the market closed at the highs, ending the week up. I think that this type of action is very telling, suggesting that the nascent summer rally is just getting started.

Another "tell" is the strength in the NASDAQ 100 (NASDAQ:QQQ), which is the first major index to clear the April highs. Already up twice as much as the S&P 500 this month, with its 3.5% gain, it had it's highest close of the year on Thursday (click to enlarge image):

I don't know about you, but this looks bullish to me. First, I don't believe in "triple tops", and early July marks the third time the QQQ has ventured above 59 (February and April). Second, the moving averages, are heading higher, with the 50dma doing a nice bounce off the longer-term average). Third, though it's not on the chart, it held the post-bubble highs of the 55-area that were set in late 2007 and now look to be very solid support. Finally, the line at the bottom, which is the relative strength (to the S&P 500), shows a huge pop like not seen since the last big rally post-Labor Day. To me, it looks like the QQQ is headed to at least 64 in the near-term.

What can we infer by the momentum shift into the largest NASDAQ companies? Before I answer that question, allow me to share some metrics and name some names for those not familiar with the NASDAQ 100.

According to NASDAQ OMX:

The NASDAQ-100 Index includes 100 of the largest domestic and international non-financial securities listed on The NASDAQ Stock Market based on market capitalization. The Index reflects companies across major industry groups including computer hardware and software, telecommunications, retail/wholesale trade and biotechnology. It does not contain securities of financial companies including investment companies.

You may recall that they rebalanced the index in early May (right at the top of the market, ironically, which is strange, because the market bottomed in June when they rebalanced the Russell). The index isn't based solely on market cap but is rather modified somewhat, as they used factors initially in 1998 ranging from 0.65 to 2.88 times the pure market-cap weightings in order to comply with IRS regulations that allowed the index to be uses as the basis for QQQ and other products. There were never any adjustments until this year for original members.

The process was somewhat complex and ended up changing several company weightings, but it didn't substantively change the sector exposures. You may recall that the weight of Apple (NASDAQ:AAPL) fell from 20.5% to 12.3%. The only names that saw a weighting increase in excess of 2% were Microsoft (NASDAQ:MSFT), Oracle (NASDAQ:ORCL) Intel (NASDAQ:INTC) and Cisco (NASDAQ:CSCO), which each more than doubled.

Looking at the index as it currently stands, it is approximately 65% Technology, 17% Consumer Discretionary and 12% Healthcare. The overall index has a PE according to Baseline slightly above the S&P 500 at 14.5X. The average doesn't do a complete job of explaining the actual PE ratios, as 14 names are below 10PE and 14 are greater than 30PE. Most names are trading well below their 10-year median PE ratios (80% median), with just 5 trading at a premium of 50% or greater. Earnings growth in 2011 is expected to be higher than the market. The vast majority of these companies have cash in excess of debt. So far this month, 15 of the 100 members are up 5%. For the year, 30 names are up more than 20%, while just 5 have fallen more than 20%.

So, what's the real story? I think that investors are gravitating to growth. This shows up when I look at components of both the Russell and the S&P indices, across all market caps. Low interest rates appear to be here to stay, and this environment of slow overall growth is leading investors to focus on those companies that can grow despite the lack of a tailwind. In 2010, looking at S&P 500 returns, Value and Growth were essentially tied. So far in 2011, Growth has about a 3% lead over Value after starting the year behind during Q1. The trend towards Growth started in March - Growth stocks have been beating Value stocks in a sideways market. I believe that the recent relative strength of the QQQ is a manifestation of this trend.

As I reaffirmed last week, I think we are headed sharply higher over the balance of the year, with the S&P 500 testing 1500 and most likely moving to an all-time high next year. Big money is clearly piling into growth stocks, which is the best way to take advantage of insanely low PEs in a sluggish economy. While it may seem like the market has moved "too far, too fast", it looks to me like we are just getting started. I continue to try to reposition my Top 20 Model Portfolio towards Growth, which has worked well with our recent additions. Rather than using QQQ, which is loaded with Technology, I have used XLK in my Sector Selector ETF model, but it's effectively the same strategy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.