Nasdaq, SMH: Have We Found a Major Top on the AI Trade?

About a month ago, we released a view on the markets being complacent when the SMH ETF was creating what looked like an inverse cup and handle against the Nasdaq chart.

It’s been 3 weeks, and since then SMH has formed a new low and lost its 20 week-EMA (1sd) against the Nasdaq, adding some validity to the view that a major top could be in.

The divergence has become increasingly difficult to ignore.

On November 4th, the S&P 500 rallied 1.6% while SMH fell 2.75%.

Then yesterday, on November 5th, the Nasdaq plunged 5.5% into correction territory, while the Philadelphia Semiconductor Index suffered a 12.2% decline.

On the raw chart itself, traders have begun to notice the similarities to the Wall Street cheat sheet as well.

Interestingly, Elliott Investment Management, the roughly $80 billion hedge fund, had already sounded the alarm in an October investor letter, warning that nearly every major indicator of an approaching bear market was flashing red.

The fund pointed towards excessive speculation, mounting debt, AI-related valuations and the risk of a self-reinforcing market unwind. It even warned that investors’ FOMO (fear of missing out) could turn into FOGO: fear of getting obliterated.

Reuters also reported that several large multi-manager hedge funds had been reducing leverage and cutting underperforming teams. Walleye Capital, a $17 billion fund, even announced plans to return some investor capital following its worst month since March 2020.

Well. Here we are today.

Many traders, including myself, have been wondering just what triggered the sell-off yesterday, and it really could come down to large financial speculators like hedge funds, beginning to experience forced-selling.

Forced selling begets more forced selling, and that’s how you can get price action like yesterday.

According to Goldman Sachs, technology-focused equity hedge funds lost more than 4% on November 5 alone, leaving their year-to-date returns roughly flat, compared with peak gains of 24% in June.

The problem is that many funds are holding increasingly similar positions. As these positions decline, leveraged investors may be forced to liquidate their holdings to meet margin requirements or reduce portfolio risk. This creates additional selling pressure, potentially triggering the same response from other investors.

As a result, sympathy sell-offs are channelling through Bitcoin and large caps (like the MAG7) as traders reduce leveraged long positions. Gold, however, has held up better during the latest equity rout, suggesting that some investors are still seeking traditional safe havens.

More interestingly, non-AI-heavy indices like the Dow are also being hit; much thanks of its 40% weighting of Tesla (NASDAQ:TSLA) and Amazon (NASDAQ:AMZN).

After what looked like what could be an interesting sector rotation into XLY consumer discretionary stocks, the Dow just felt brutally after touching the midline of its rising channel.

And MAGS broke its weekly rising trendline, and the Nasdaq-100 has also fallen below its 20-week EMA Bollinger band (1sd), and Bitcoin is also below its daily 20-period EMA band.

Even the Russell 2000, comprising of mostly small caps, was hit hard, with it now sitting on top of a weekly support level. So this sell-off is looking less like a sector rotation and more like market-wide contagion.

Of course, forced liquidation may not be the only catalyst behind the decline.

Investors are also becoming increasingly concerned about the sustainability of the AI investment boom, particularly the enormous capital expenditure commitments, rising financing costs and uncertainty surrounding future returns.

The recent Democratic midterm victories have added another layer of uncertainty, with investors questioning whether tighter restrictions on data-centre development could slow infrastructure spending and, consequently, demand for semiconductors.

If the Wall Street Cheat Sheet’s complacency analogy holds, a recovery from here could be brief before another leg lower. That remains a scenario to be seen and not a definitive outcome at this stage.

The question now is whether this is simply a violent positioning reset, or the beginning of a more fundamental repricing of the AI trade.

Bottom Line

For now, the SMH/Nasdaq relative-strength chart remains an important indicator to watch. A recovery above the broken weekly EMA band could suggest that the recent breakdown was temporary.

Continued weakness, however, would add further weight to the possibility that semiconductor stocks have already signalled a major market top.

Disclaimer:For educational purposes only. Trading comes with substantial risk, leading to possible loss of your capital. Traders are advised to do their own due diligence before investing.