THE NASDAQ 100 HIT A RECORD HIGH THIS WEEK, BUT STILL LAGS BEHIND THE S&P 500 OVER THE LAST MONTH -- RISING BOND YIELDS HAVE CAUSED THE QQQ TO LOSE MOST GROUND AGAINST FINANCIALS AND SMALL CAPS -- THE QQQ IS ALSO LAGGING BEHIND ITS EQUAL-WEIGHT VERSION

NASDAQ 100 HITS NEW HIGH... Chart 1 shows the Powershares QQQ ETF hitting a record high this week. It was the last of the major stock indexes to do so, and its breakout is a positive sign for the market. It also did slightly better than the rest of the market. The QQQ, however, has still been a relative laggard over the last month. That's shown by the falling QQQ/SPX ratio since the start of September (blue line). This week's upturn in its RS line may be a sign that some funds are flowing back into large tech stocks. But there's more going on beneath the surface with the QQQ. For one thing, comparing the QQQ to the S&P 500 doesn't fully reflect QQQ recent underperformance. That's because the S&P 500 itself has been an underachiever over the last month (relative to smaller stocks). To get a truer picture we have to compare the QQQ to the groups that have been getting most of the tech money. Financials have been the biggest beneficiary of the past month's rotation out of techs. That's been tied to the upturn in bond yields, and growing expectations for another rate hike in December. The reasons why financials usually outperform techs when rates are rising have been described in previous messages. Let's compare their recent relative performance.

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Chart 1

QQQ HAS DONE WORST AGAINST FINANCIALS ... Anyone still doubting that a significant sector rotation has been going on need only look at the next chart. The blue bars in Chart 2 plot a relative strength ratio of the PowerShares QQQ divided by the Financial Sector SPDR (XLF). The bars show the QQQ underperforming the XLF by a wide margin since the start of June, and again during September. Since the start of June, financials have nearly tripled QQQ performance (14% versus 5%). Since the start of September, financials have outperformed the QQQ by a 7% to 1% margin. Rising bond yields have been the main reason why. And signs of a stronger economy. Three other economically-sensitive sectors outperforming the QQQ over the last month are the industrials (including transports), energy, and materials. That shows that money has also been flowing into parts of the market that do better in a climate of rising rates and a stronger economy. Those three sectors have doubled the performance of the QQQ over the past month. They also hint at rising inflation which would support higher interest rates.

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Chart 2

SMALL CAPS HAVE DONE A LOT BETTER THAN THE QQQ... Another recent rotation has been from larger to smaller stocks. Chart 3 is a ratio of the QQQ divided by the Russell 2000 Small Cap Index ($RUT). The falling ratio since the start of September reflects underperformance of the QQQ relative to small caps. Since September 1, the RUT has outperformed the QQQ by a 7% to 1% margin. That's tied to bond yields which started rising sharply in September. For reasons explained in previous messages, small caps do better in that environment. For one thing, small caps have a much higher exposure to financial stocks which have been market leaders. In addition, small caps are more responsive to a stronger U.S. economy. They also stand to benefit more than large caps in any reduction of corporate tax rates. A bouncing dollar also favors small caps. Chart 2, however, also shows the QQQ/RUT ratio having fallen close to a potential support level formed at the start of July. And it's starting to bounce. That suggests some unwinding of recent rotation trades (which could explain this week's bounce in several big tech stocks). Rising rates and a stronger economy, however, may prevent technology stocks from regaining their 2017 leadership position.

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Chart 3

ROTATION TO SMALLER STOCKS WITHIN THE QQQ... There's also evidence of some recent rotation to smaller stocks within the Nasdaq 100 itself. And it can be seen in our final chart. Chart 4 plots a ratio of the Powershares QQQ divided by the First Trust Nasdaq 100 Equal Weighted ETF (QQEW). The falling ratio shows underperformance by the QQQ since August 21 (by a 6% to 4% margin). Here's why. Both ETFs include the 100 largest non-financial stocks in the Nasdaq market. Technology dominates the QQQ with a 58% weight. The QQQ, however, is a cap-weighted index. That gives greater weight to its biggest tech stocks like Apple (11%), Microsoft (8%), Amazon (7%), Facebook (6%), and Alphabet (5%). Those five stocks account for nearly 40% of the QQQ. The QQEW is made up of the same 100 stocks. But it gives each one an equal weight of 1%. That reduces the impact of the five biggest stocks in the QQQ to only 5%. The falling ratio since August 21 shows more preference for smaller stocks in the QQQ. Interestingly, August 21 was the same day that the Russell 2000 Small Cap Index turned up and started to outperform the S&P 500. Like the three ratios shown in the previous charts, the one in Chart 4 has also bounced this past week. That may also explain why the QQQ joined the QQEW in record territory this week.

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Chart 4

IT'S ALL ABOUT RELATIVE NOT ABSOLUTE PERFORMANCE... The purpose of this message is to demonstrate once again that subtle rotations have been going on beneath the surface in the U.S. stock market. One is the shift to more cyclical value stocks that do better in a stronger economy with rising rates, and out of growth stocks (like technology) which are favored in a slower economy. The second is the shift into smaller stocks that do better in a stronger U.S. economy. These rotations have had no negative impact on the direction of the overall market which continues to set new highs. This is more about "relative" than "absolute" performance. All the major stock indexes, and most market sectors, are rising. But some are rising faster than others. Which ones are rising faster tell us something about the outlook for the stock market in a stronger economy with rising interest rates. They also suggest where investors might want to do some rotating of their own to ensure that they're properly positioned for the current economic environment.