Last week’s Nasdaq selloff may well have marked the bursting of one of the biggest bubbles in modern history that could easily result in a 75% market drop over the coming years. The two days of losses not only wiped out several weeks of gains but also wiped out the equivalent of years of dividend payments. As the prevailing psychology shifts from maximizing gains to minimizing losses, investors are likely to require a much higher risk premium to hold stocks. The decline in prices needed to restore even long-term average return prospects would mean a market plunge that may currently seem unimaginable.
The Current Bubble May Be The Most Extreme On Record
There are numerous ways to measure the size of a market bubble. One of the most useful for comparing across different countries is the price-to-book ratio, and on this measure, the current Nasdaq bubble is only eclipsed by itself two decades ago. The current P/B ratio on the Nasdaq dwarfs the Shanghai Composite in 2008 and the Nikkei in 1989.
Source: Bloomberg, Author’s calculation
It could be argued that the P/B ratio is not the best measure of the size of a market bubble, as the Nasdaq has a far higher return on equity currently than it did in 2000, and also compared to the Nikkei and Shanghai peaks, largely justifying a higher P/B ratio. On a price-to-earnings basis, the recent peak of 40x for the Nasdaq pales in comparison to the dot com peak as well as the Japanese and Chinese bubbles.
However, it is the very fact that sales and earnings have been so strong in the past that strongly suggests future growth will be considerably slower. Back in 2000, there was the prospect for the Nasdaq to “grow into its valuation”, whereas today, the prospects for growth are considerably weaker. This differentiates the current bubble to that of 2000 and suggests to us that the outlook facing the Nasdaq is even worse than it was in 2000. With this in mind, we believe the measure that captures to extent of the Nasdaq’s dismal returns prospects best may be market capitalization as a share of GDP. On this metric, the Nasdaq bubble actually exceeds that of the 2000 peak by a wide margin.
Source: Bloomberg, Author’s calculation
Strong Growth Always Comes At The Expense Of The Future
As has tended to be the case during major market bubbles, investors have extrapolated the strong earnings growth of recent years into the future despite the tendency for above-trend past growth to give way to below-trend future growth. As was the case in the late 1920s, the late 1990s and the early to mid-2000s, Nasdaq sales have grown at a much faster rate than their historical average, which has allowed profit margins to rise and profit growth to far exceed historical averages.
From 2000 to 2020, U.S. tech sector revenues have grown by around 9% per year, with the 2000-2010 period registering 8% and the 2010-2020 period registering 10%. The acceleration in sales over the past decade has allowed earnings to grow at 13% per year, considerably faster than their long-term average. Investors appear to be extrapolating continued rapid earnings growth, which would require an implausible surge in sales over the coming years. Much more likely is a gradual decline in sales growth and a sharper decline in earnings growth.
We often here the argument that the FAAMGs are so entrenched in most people’s lives that these companies will continue to do well. However, it is the very fact that these companies have managed to dominate the U.S. and global economy that will mean slower sales and earnings growth in the future. If we take the example of Microsoft (MSFT), while the company’s products are indispensable for a large number of users who may well pay much more for products and services, the fact is that after a seven-fold increase in revenue over the past two decades, there is now a much smaller market for its products to grow into. The boom seen over the past five years is unlikely to change the long-term trajectory of slowing revenue growth. Despite this, Microsoft traded at 40x earnings at its peak on September 2, a ratio last seen in 2003, following which the stock went nowhere for a decade.
As we argued in July (see “NDX: A Lost Decade Awaits As Bubble Rivals Dot Com Era“), Nasdaq sales growth is likely to gradually slow towards the rate of nominal GDP growth, as has been the rule rather than the exception for large companies which dominate their industry.
Source: Hussman Funds
The Maths Behind A 75% Decline
A 75% decline seems almost impossible to imagine, yet, all it would likely take is for the required rate of equity returns to fall back to the long-term average. Over the long term, U.S. stocks have returned 10% per year in total return terms from peak to peak and trough to trough, and there is little reason to expect investor psychology to have changed in recent years. If we assume Nasdaq’s dividend payout ratio increases from its current level of 28-40% in line with the SPX long-term average, a 40x P/E ratio translates to a 1% dividend yield. This means that sales and earnings would need to grow by 9% in order for the Nasdaq to return 10% per year.
However, if sales and earnings growth slow to the rate of long-term nominal GDP and SPX earnings growth of 6%, a 75% decline in prices would be required in order for the dividend yield to rise to 4% and total returns to rise to the 10% historical average. It is not worth thinking about what would happen to stock prices if investors drove up future return prospects to above long-term averages or sales growth were to come in at the more recent 4% trend nominal GDP growth rate.
Beware, There Is Always A Compelling Narrative
While U.S. stocks have returned 10% per year over the long term, these returns have fluctuated to an incredibly high degree as markets routinely move from undervalued to overvalued and back again as investors extrapolate gains and losses. When investment returns are so strong in the rear-view mirror, investors become convinced by the narrative that accompanies the gains.
Today, that narrative is built around the idea that with deeply negative interest rates, mega-cap tech stocks are attractive equivalents to long-term bonds given their high levels of cash flow and negligible default risk. However, this is a classic case of markets moving first and the narrative following. The more stocks have risen, the more investors have become convinced that extreme valuations are justified by low interest rates.
The fact that stocks managed to rebound strongly the March lows has strengthened the bullish convictions among many investors. If the Fed can trigger a rebound even amid a global pandemic, what could possibly take the market down? Investors have become so convinced in the fundamental story that they were willing to pay any price to get exposure to it, setting up the inevitable crash.
As red ink continues to mount, an equally compelling narrative is likely to develop as stocks begin to decline, as has been the case following the bursting of every bubble throughout history. Slowing growth, declining profit margins, rising inflation, political uncertainty and deteriorating U.S.-China relations are just a handful of potential narratives that will be used to explain why stocks are falling.
Low Rates Will Not Make It Different This Time
We have heard investors argue that with real interest rates 5 percentage points lower than at the 2000 peak, downside is limited, as there are few alternatives to stocks to invest in. The problem is that history has shown time and time again that low returns on bonds provide no guarantee against even lower returns on stocks (see “Faith In The Fed’s Ability To Support Stocks Is Unfounded“). Those who view interest rate cuts as supportive of equity prices should bear in mind that aggressive cuts did nothing to prevent the bursting of the dot com bubble and the scope for further cuts today is far more limited than was the case back then.
The fact of the matter is that when the psychology of investors shifts from maximizing gains to minimizing losses, even 0% returns on cash become much more favorable for risky stocks. The primary reason being that losses tend to occur at the worst possible time, when dividend income and employment income is most uncertain.
Disclosure: I am/we are short NDX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Originally published on Seeking Alpha