Party Like It’s 1999

Party Like It’s 1999

The Nasdaq 100 (QQQ) had the best-ever start to a year in its history, up 39%. Why did this happen, and more importantly, what should we do about it?

Even agreeing on just what caused the historic surge seems like quite a challenge. We can say that the index lost almost a third of its value in 2022, so some amount of reversion doesn’t seem too shocking. It’s also worth noting, as an aside, that QQQ is still below all-time highs, as geometric returns means you have to gain 50% to get back to even, after losing a third of your value.

Besides mean reversion, what caused the move? We know it wasn’t earnings growth. The great majority of the move came from multiple expansion, as can be seen in the chart below.

That’s OK, as the move is coming from companies leading the charge in our AI-fueled future, right? Trailing earnings weren’t great, but the future looks good! The thing is, valuations do matter eventually, and that tends to become more immediate when the discount rate is higher. With 5%+ risk-free rates being commonplace, now, ignoring valuations seems much more dangerous than the last time we played this sort of game.

Aswath Damodaran, NYU Business School professor and owner of Nvidia (NVDA) brought up this valuation question, recently. As usual, that blog from him is long and complete, but the basic conclusion is that shares are likely significantly overvalued. In addition to the AI boom, you’d probably need another boom or two of similar scope to justify the price.

Admittedly, NVDA is probably the most aggressively priced, at 41x P/S, where 10x P/S is usually considered extremely aggressive. However, MSFT is as 12x P/S, AI is at 16, and even a fairly tertiary player like AAPL is at 8x. Historically, these are very aggressive valuations.

I find the whole forward earnings talk unsatisfying. Accenture, for instance, believes that generative AI is unlikely to be a big growth driver next year. Considering the investments that are being talked about, it seems to me like it’s more likely AI represents more of a cost than a near-term profit center.

Is there anything else to explain or justify the incredible gains in the tech sector, YTD? I think there is. Cem Karsan of Kai Volatility is an expert on the options and volatility markets. He believes volatility has been pinned, but macro flows are weak. The only way you can support that sort of a structure is if you have a few large stocks carrying the water. In this case, that’s tech. Thus, tech soars, most of the market suffers, and volatility stays low. Right or wrong, it certainly describes the market accurately, though nothing must resolve immediately.

OK, then, what would happen next? We had something very similar happen in 2018, which brought about Volmageddon, where volatility soared and stocks plunged. Realistically, though, a situation like this could get resolved through some combination of time and price. The situation could explode, deflate over time, or some combination of the two.

As the chart above shows, tech has outperformed to a historic degree over the market. Honestly, there’s probably a variety of reasons it happened, whether it be reversion, option market games, growth prospects, or simple performance chasing. The big question, however, is what happens going forward.

It’s hard to swing a dead rat without hitting some article talking about how good an omen it is that we saw big gains, and surely there’s more to come. Probably unsurprisingly, I wouldn’t join in on chasing historically expensive stocks. I understand that people are excited that they could be getting back to even on their tech losses from last year, but hope is a lousy process.

The below chart is basically anecdotal, but it’s worth pointing out that the only other time we had a better half-year was the end of 1999. Boy, optimism was high, then. That turned out to be the final paroxysm of a historic tech run. Admittedly, it looks like tech highs were probably reached last year, but are these really the valuations to start a new tech run?