US stock indices have staged a powerful rally since October 2022, which is mainly driven by a few tech giants that are anticipated to realise significant gains from the boom in artificial intelligence (AI). However, the market has reached a stage where valuations are overstretched, liquidly is drying up, earnings are stagnating, and the Fed shows no signs of backing off from its aggressive stance. Could this be the beginning of a correction?
Stellar performance but limited upside left
The major US indices have exhibited remarkable performance since the beginning of the year, appearing unhindered by the banking turmoil and the debt-ceiling crisis, even as market anticipations for a more accommodative Fed have been repeatedly disproved. Both the S&P 500 and Nasdaq have entered a technical bull market, posting fresh 14-month highs before paring some gains in the last few daily sessions.
Taking into account the fundamental outlook, stocks seem way overpriced at current levels, thus it makes more sense for investors to start diversifying rather than keep inflating a market that looks ready to explode. After all, a short-term pullback is healthy for any bull market as it is reasonable for the price action to reverse towards its longer-term trends.
Risks slowly tilt to the downside
But why do many market participants advocate that the time for a correction has come? Firstly, Fed Chair Jerome Powel struck a hawkish tone in his testimony before the House Financial Services Committee, stating that there are more interest rate hikes to come and higher borrowing costs are likely to suppress growth in the upcoming months. Moreover, as interest rates are set to remain high for a prolonged period, bond yields could look relatively more attractive than stock earnings, making bonds a better risk-adjusted investment than equities.
In addition, no one can argue that the AI mania, which is the main driving force behind the latest rally, could not provide significant long-term gains and be the next big thing in markets. Nevertheless, at the current stage, AI-related stocks seem to be priced for perfection and it is highly unlikely for all of them to reach that potential. The dot-com bubble could serve as a good example because on the one hand the internet proved to be a significant thing for the years to come, but just a small number of companies managed to live up to the excessive expectations.
Finally, we have seen the Nasdaq 100 getting dragged higher by just a few tech giants, which collectively make a significant percentage of the index, while most other stocks are either flat or underperforming. Historically, a sustained rally has never occurred when small-cap firms are trailing so far behind the blue chips.
Nasdaq 100 in critical territory
Taking a technical look at Nasdaq 100, we can see that the price has been experiencing a pullback after failing to cross above the 14-month high of $15,280, which also provided resistance in March 2022. Generally, it is common for financial instruments to reverse their trajectory after failing to conquer historical support or resistance levels.
Should the pullback extend, the price could encounter support at the $14,650 hurdle. Failing to halt there, June support of $14,290, which also acted as resistance in April 2022, could prove to be the next barrier for the bears to overcome.
On the flipside, bullish actions could propel the price towards the recent 14-month peak of $15,280. A break above that zone could bring the September high of $15,700 under scrutiny.
