Tech Rotation Sparks Striking Dow, Nasdaq Divergence

The S&P 500 Index (SPX) and Nasdaq Composite (IXIC) suffered their worst week since June on Friday

There were some notable developments in the stock market last week. The S&P 500 Index (SPX) and Nasdaq suffered their worst week since June, falling 1.9% and 4.5%, respectively. Meanwhile, the Dow was slightly higher for the week.

This week, I’ll focus on the divergence between the Dow and Nasdaq. I’ll look at the historical data to see if there are future implications for last week’s rotation from the tech-heavy Nasdaq stocks to the large-cap Dow Industrial stocks.

Large-Cap Divergence

Before I start filtering the returns, the tables below summarize Dow and Nasdaq returns over various timeframes. The tables give us a baseline for how the indexes typically perform. Since 1980, the Nasdaq has outperformed the Dow by average return. The Nasdaq has tended to have higher volatility as measured by the standard deviation of returns and it beats the Dow a little over 50% of the time at each timeframe.

Since 1980, there have been 28 prior occurrences of the Dow beating the Nasdaq by 5% or more during a week. The tables below show how the indexes performed after those weeks.

These weeks tended to be followed by a bounce-back week with both indexes averaging a return of more than 1.5% the next week. After that, however, there was significant underperformance. In the three months after the Dow beat the Nasdaq by 5% in a week, the Dow averaged a return of just 1.6% while the Nasdaq averaged a loss of 1.3%.

The poor returns are due to a majority of the signals occurring during the tech bust between 2000 and 2002. Last week’s Dow/Nasdaq divergence could be seen as evidence of being in the early stages of an AI stock bust.

Here’s one more way I looked at it. The table below shows there were 16 previous instances of the Nasdaq losing 4% or more during a week in which the Dow was positive. Again, the data shows both indexes tended to make big gains in the next week. This time, however, they don’t fall off so hard going forward. One month after these instances the Dow gained 1.95% on average versus a typical one-month return of 0.77% for the index (from the first table in this article). The Nasdaq was up 2.4% on average after the first month after a signal versus a typical monthly return of 1.0%. In these cases, the Nasdaq beat the Dow 63% of the time over the next month of trading.

One thing notable about these instances is that the Dow volatility going forward is in line with its typical volatility. The Nasdaq, however, shows much more volatility than normal after these signals.

These next two tables show the individual dates when the Nasdaq lost 4% or more during a week that the Dow was positive. The tables show only three occurrences in the last 20 years, including the recent one. The rest of these signals occurred just before, during, or just after the tech bust.

Don’t Bet on an AI Tech Bust Just Yet

I would refrain from drawing strong conclusions from the data based on so few signals outside of the tech boom/bust period. I could see some people using last week’s signal as a warning of an AI tech bust. However, there were huge gains to be had still after the early signals before the tech bust.