There's a major disconnect in the Nasdaq rally.
While the broad index sits at record highs, under the surface more than half of its stocks are in a bear market – characterized by a drop of 20% or more from 52-week highs.
"The Nasdaq has been really strong from a momentum perspective, but the leadership has been relatively narrow," Katie Stockton, founder of Fairlead Strategies, said Wednesday on CNBC's "Trading Nation."
Mega-cap stocks such as Apple, Microsoft and Amazon have been responsible for much of the Nasdaq's rally. But, the charts may be signaling that more Nasdaq stocks could be about to join in on the rally, Stockton said.
"Believe it or not, breadth for the Nasdaq, while it usually is disadvantaged compared to the NYSE, has not been that bad. We saw it range-bound for much of 2019 but a breakout in Q4, and that breakout supports greater expansion in the participation among Nasdaq stocks as we see the market resume its uptrend, whether it happens now or a couple weeks from now once the pullback runs its course," said Stockton.
That doesn't mean investors should buy the laggards, though, she cautioned. Align Technology, Dollar Tree, Ulta Beauty, Walgreens and Xilinx are among the stocks that are sharply off their highs and deep in a bear market.
"As a technician, I'm not comfortable buying downtrends unless you see some kind of basing phase. In fact, one of the ones mentioned, Align Technology, we've had on our list of recommendations on the short side, and we have that there because it met some resistance, lost some momentum within its downtrend. So I'd say generally speaking, we try to avoid the stocks that are in long-term downtrends and really find the stocks that are exhibiting leadership," said Stockton.
Orthodontic tech company Align has added 10% in the past 12 months, a fraction of the nearly 30% gain on the broader Nasdaq.
During the same "Trading Nation" segment, John Petrides, portfolio manager at Tocqueville Asset Management, said the Nasdaq stocks in a bear market could continue to grind lower.
"There's two functions going on," he said. "One is valuation and the other is fundamentals. Growth stocks have rallied hard, and expectations for future cash flows got far ahead of themselves. So, there are some stocks on the [bear market] list where it's purely a valuation call and if momentum does come out of growth, those stocks are going to continue to have pressure."
He added that these stocks are also getting hit on fundamentals. Xilinx, for instance, has seen an a chip pricing war ratcheting higher, while excess big-box retail expansion could crimp Dollar Tree.
