The NASDAQ’s fall was bound to happen, and it’s still not nearly deep enough to hit bedrock. The powerful momentum driving tech’s shooting stars ever skywards is finally surrendering to market gravity. The “innovation-at-any-price” high spirits that sent the NASDAQ shooting into the stratosphere over less than three years, is giving way to the realization that its members can’t grow profits nearly fast enough to give you a decent return. The reason is basic: These stocks are still just too damn expensive. Put simply, the fundamentals are taking hold following a long and crazy ride. The more unhinged prices became, the steeper the fall that was bound to follow––and most likely, we’re witnessing the early stages of that inevitable descent right now.
Gravity is finally taking hold
How deeply will the NASDAQ drop? To make a reasonable estimate, let’s unpack the traditional metrics that are reliable predictors of equity price trends over long periods, and address the question: What’s the NASDAQ really worth? The NASDAQ 100 that represents the vast bulk of the overall index’s valuation has already entered correction territory, shedding 10% from the close of 2021 to stand at 14,438 at the close on Friday, January 21, and down 13% from its all-time high, set on November 19, of 16,573. Among the glamour, stay-at-home economy luminaries that suffered the biggest hits since then: Zoom (down 41%), Netflix (-42%), Peloton (-43%), and Docusign (-56%).
So far the slide’s too modest to make the NASDAQ 100 even close to a good buy. It remains hugely overvalued because in recent years, its prices have risen far faster than earnings, giving investors fewer and fewer cents in profit for each dollar they’re paying. That disconnect has raised the bar for the future earnings growth the index must reach to deliver an acceptable return beyond what’s even remotely achievable. Now, it looks like folks and funds will keep dumping until they’re getting a lot more bang for their buck.
Prices rose much faster than profits, putting the NASDAQ in a bind
Let’s look the NASDAQ 100 as one big company by combining its members’ market caps, profits and revenues. We’ll call it One Hundred, Inc. At the close of 2018, One Hundred, Inc. sported a market cap or “price” of $7.46 trillion, and posted GAAP net profits, measured over the trailing four quarters, of $334 billion, for a PE of 22.3, well above the index’s long-term average. In 2019, One Hundred enjoyed a banner year, gaining 34%. It wasn’t a profit surge that propelled the increase; earnings rose less than 5% to $350 billion. Its valuation jumped by seven-times as fast as profits to $10.1 trillion, lifting its multiple to 28.9.
One Hundred, Inc. was just warming up. For 2020, it clinched a 43% gain, lifting its market cap to $15.5 trillion. But profits lagged once again, reaching just $373 billion, an increase of 6.6%. Its PE soared to 41.5, almost twice the figure two years earlier.
The party kept roaring in 2021. By year end, One Hundred had gained another 21%, sending its valuation to $20.1 trillion. This time, profits danced, jumping by 50% to $561 billion. That performance lowered its PE to 35.8. Still, over those three years, One Hundred’s price rose 170%, two-and-a-half times its profit growth of 69%. Result: One Hundred, Inc.’s shares got 60% more expensive as its PE jumped from roughly 22 to 36.
Since the close of 2021, our NASDAQ, Inc.’s valuation has fallen 11.5% to $17.8 trillion. Hence, its multiple has shrunk by the same proportion to 31.7. That still looks pretty expensive, but that number is still artificially low. That’s because as we’ll see, the denominator––the 100’s earnings––are highly inflated, and destined to fall or go flat.
The incredible drop in rates sent PEs rising much faster than profits
Warren Buffett explained it best: Relatively risky stocks compete with safe government bonds, so when bond yields drop, the appeal of fixed income securities falls, and money shifts to equities. Investors can pay a lot more for stocks and still get more dollars in earnings for the dollars they’re paying for each share than they’d pocket from the puny yields on Treasuries. What’s more, the profits that provide those dividends and capital for expansion keep growing, while bond coupons don’t. In this dynamic, a big fall in interest rates usually triggers a sharp rise in price-to-earnings multiples––just what happened from the early 1980s to mid-1990s.
From late 2018 to today, the yield on the 10-year Treasury has dropped from 3.2% to 1.75%. What matters most, though, isn’t the slide in “nominal” rates that are posted every day on business TV channels and sites, but that number adjusted for inflation––what’s known as the “real yield.” It’s the shifts in the real yield that sink or boost stock prices. Over that three year period, that crucial benchmark swung from a positive 1.1% to the current negative 0.58%.
How do we arrive at that number? it’s the difference between the expected annual inflation of 2.33% over the next decade (based on the rate for Treasury Inflation-adjusted securities) and the 1.7% yield or the long-bond. The historic fall in real yields powered the gigantic increase in the our One Hundred, Inc, by enabling the index’s prices to race much faster than its profits.
This math shows what the NASDAQ’s really worth and it’s a shocker
The market’s PE is determined by the “cost-of-capital.” It’s the return that investors, at this very moment, are demanding to buy stocks. A good approximation of the COC is the current “earnings yield.” It’s the dollars you “receive” in profits for reach $100 you’re paying for a stock or group of stocks like the NASDAQ 100. Divide $100 by the current PE of 31.7, and you get 3.15%. Your share of NASDAQ, Inc.’s profits for each $100 you own in its stock is $3.15. That just-over 3% number is low by historical standards, and it was a lot lower at 2.8% at the end of last year before tech started tanking. The reason that investors are willing to accept relatively paltry earnings for the every $100 or $1000 or $100,000 they’re paying for stocks is that bonds are an even worse deal.
But that’s going to change. In December, the Fed was already predicting that it would lift the short-term Fed Funds rate from virtually zero today to 1.6% in 2023, 2.1% in 2024, and 2.5% over the longer term. Chairman Powell’s announcement in January that the central bank will do whatever it takes to wrestle down rampaging inflation probably means the Fed will raise faster, and higher. Since escalating short-term rates generally send all yields on longer-dated bonds higher, it’s probable that “real” yields will soon go positive.
Steep drops ahead
How positive is the question. Let’s be conservative. The CBO’s projections for economic growth going forward is in the 2% range. Real rates generally track the expansion in GDP. But U.S. real rates could be much lower than 2% if foreign nations continue their strong demand for dollars as a safe haven. We’ll estimate that real rates rapidly go from the current minus 0.58%, to 1%, still an extremely low number by historical standards.
So let’s do the math. Working backwards, if real rates hit 1%, investors will demand a higher return from our One Hundred, Inc. They’ll want not an earnings yield of 3.17%, but one that tacks on the increase in rates, in what they could get from risk-free bonds. And getting to a 1% real rate means a rise in real rates of 1.58%––going from today’s yield of minus 0.58% to 1%. When investors predict that will happen, they’ll want a return or earnings yield that’s 1.58% higher than today’s. So add 1.58% to the current earnings yield of 3.17%, and you get 4.75%.
The 100’s PE would be the inverse of that 4.75%, or 21. At that multiple, One Hundred Inc, at the current $561 billion in trailing earnings, would fall to 11,840. That’s 18% below the 14,438 close on January 21. The total drop from the November record would be 29%.
But hang on.
That the recent earnings season is studded with disappointments––including the big miss at Netflix––is a harbinger of things to come. The One Hundred’s earnings are in a bubble. In 2018, a strong year, it achieved a net-income-to-sales margin of 13.8%. Last year, that bulge swelled to 17.0%. That kind of profitability won’t last. Economist Robert Shiller’s CAPE index that “normalizes” earnings by averaging profits over a decade, suggests that One Hundred, Inc’s had an unusually great year in 2021, and that net profits should revert to around $400 billion, way below the $561 billon recorded in 2021. Even if we assume that the stay-at-home economy has given the NASDAQ greats a long-term profit boost to $450 million, the index at a PE of 21 would sell for 9500.
What’s the NASDAQ really worth? By this writer’s analysis, around that 9500, meaning it’s got another 34% or so to fall. We saw this spectacle in the aftermath of the 1998 to 2000 tech bubble. That was all about dot com newcomers with huge valuations and no earnings. This time, it’s about a big multiples on top of inflated earnings. Both will decline as rates return to normal levels, and the profit bonanza from the stay-at-home economy that enriched so many tech players wanes. Getting back to normal will be painful indeed.
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