The NASDAQ is In a Bubble – Definitely! Here’s Why

Lorimer Wilson February 20, 2014 Comments Off on The NASDAQ is In a Bubble – Definitely! Here’s Why 2,247 Views

Investors generally assign higher multiples to many Nasdaq firms, as they expect significant future growth, but if volatility ensues and growth, which is already priced in, isn’t realized by these firms…a violent reaction to broken promises [will ensue just as]…happened in 2000. [For that matter]…there are a number of similarities between the current level of the Nasdaq index and back then that strongly suggest that the bubble is here. Let me explain why I believe that is the case.

So say edited excerpts from an article* by NYC Trader posted on SeekingAlpha.com entitled Yes, The Nasdaq Bubble Is Definitely Here.

[The following is presented by Lorimer Wilson, editor of www.munKNEE.com and may have been edited ([ ]), abridged (…) and/or reformatted (some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. This paragraph must be included in any article re-posting to avoid copyright infringement.]

The article goes on to say in further edited excerpts:

Index Level

As the chart below shows, Nasdaq traditionally moves in line with the S&P 500. Over the last 20 years, that correlation has broken twice, during the dot com era and today, as you can see. As evident, after being perfectly correlated since about 2001, starting in around 2009, the Nasdaq began trading at a premium to the S&P 500, something that does not agree with historical trends.

(click to enlarge)

In fact, as the chart shows, the last time the Nasdaq traded at bubble levels, it reverted to the exact levels of the S&P 500. That makes intuitive sense. The S&P 500 traditionally includes larger and more established growth and value corporations that trade at relatively lower multiples than the Nasdaq. These companies are cash-rich, compete through scale, and are likely to capture share of “growth” markets and challenge smaller firms. On the other hand, while Nasdaq does include some of the same large cap firms, traditionally the Index also includes small cap growth corporations, and investors generally assign higher multiples to many of the Nasdaq firms as they expect significant future growth.

This could create upside – if valuations are reasonable and growth is attainable – specifically when times are good. However, unreasonable valuations could create dangerous prospects for the Nasdaq firms if volatility ensues and growth, which is already priced in, isn’t realized by these firms. Instead, what you get is a violent reaction to broken promises. This is what happened in 2000. While we’re likely nowhere near the risk and valuation levels of 2000, it is fair to say that many of the companies in the Nasdaq Composite are valued at unfairly high valuations while beginning to face serious challenges.

Also, what’s most dangerous about the Nasdaq is the risk of industry concentration within the Index. While the S&P 500 includes some of the same firms in its Index, the S&P constituents are scattered more broadly across industries. For example, a serious challenge within tech in the S&P 500 is naturally hedged with defensives and other industries. The Nasdaq, on the other hand, is concentrated mostly in tech. If some of the large cap tech stocks experience pain, this would immediately translate to a broad Nasdaq pullback because of a strong correlation of its constituents to the same industry.

Valuations

…While it’s true that the Nasdaq includes firms that are currently valued at extremely irrational multiples relative to Nasdaq’s average, the Index also includes firms that are valued at multiples that trade well below its average. Below is a table of Nasdaq stocks and its multiples. I’ve broken them out into 2 groups – “value” and “growth”.

(click to enlarge)

Value stocks are currently trading at a deep discount to the Nasdaq average, which is 30X, and growth stocks are trading well above the Nasdaq average. This is also what differentiates this era from the prior era. These “value” stocks that are trading at a discount are likely pulling down the Index P/E from reaching levels seen during the dot com era and disguising the higher multiples of their peers in the Index…

Investors continue to bid up prices of growth companies. The eight growth companies described in the table above are collectively valued at $1.1 trillion, while annual earnings for all eight are only 57% of Apple’s entire annual earnings. The eight firms also collectively have less revenue and less cash than Apple. These are risky levels, and any sell signal in these companies could naturally pave the way for a Nasdaq crash.

Conclusion

As investors process the recent 5-year 200% Nasdaq gain, they should consider the similarities between these levels and those seen in 2000. If you know your stock is trading at unusually high levels that you can’t explain, use your market value gains to buy something real…