Is the Nasdaq 100 another Dot-Com Bubble?
The outperformance of the tech-heavy Nasdaq 100 (NDX) since the financial crisis has prompted a bevy of comparisons to the infamous dot-com bubble. At first glance these concerns are understandable; from 01/01/2009 to 18/09/2020 the Nasdaq 100 delivered a whopping 916% total return vs. 369% for the S&P 500. This translates into a compound annual growth rate (CAGR) of 21.91% relative to 12.23% for the S&P 500. Like the Nasdaq during the dot-com boom, it is hitting all time highs again, but that is where the similarities end.
Source: YCharts
*Invesco QQQ Trust is an exchange-traded fund based on the Nasdaq-100 Index
Difference
These comparisons are misguided for principally two reasons, valuation and fundamentals. Firstly as of September 18, the price to earnings ratio of the Nasdaq 100 stood at 35, whereas during the late 1990’s it traded at 75 times earnings. The key difference between then and now is that earnings growth have mostly managed to keep up with today’s valuations. See the chart below by Goldman Sachs Global Investment Research, which highlights the primary reason for the outperformance of US technology — exceptional fundamentals. According to Nasdaq, NDX has posted a CAGR in earnings of 21% since 2003, earnings growth is the fundamental driver of returns. Today, fundamentals are strong enough to support high prices; this wasn’t the case during the 1990’s tech bubble.
Another Era
During the 1990’s the internet captured the collective imagination of investors, at the time they would throw money indiscriminately at any company with dot-com attached to it. Many companies lacked viable business models, failed to generate any profit or cash flow and subsequently went out of business (see Pets.com and Webvan) — the dot-com boom was driven by irrational exuberance.
I see the failed WeWork IPO last year as a positive signal of a market which is doing its job and an indication that investors are unwilling to accept eye-popping valuations for unprofitable IPO’s and tech firms in general — the days of pouring endless capital into loss making businesses are gone. Moreover its a sign that investors have learnt their lessons from the heady days of the dot-com mania, and how far away we are from the past euphoria for internet related companies.
This time is always different
Today’s Nasdaq 100 is a collection of highly profitable, cash generating behemoths with monopolistic positions. Companies such as Apple and Microsoft are making profits on a scale that the internet firms of the dot-com era could scarcely imagine. The index is weighted towards high-performing, mark-leading companies in the ‘new economy’ and has no exposure to ‘old economy’ sectors such as oil & gas and basic materials — the premium valuation is the price for quality businesses with superior growth prospects.
However not all technology firms are equal; there are a handful of companies whose prices have little bearing to reality. For example Tesla’s stock price has quadrupled this year despite not generating a profit and Netflix is trading on an lofty 80 times price to earnings even though they have a unsustainable business model.
In my previous post ‘Buy FAANG stocks at your own peril’, I pointed to rich valuations and large inflows as a warning to be cautious as this tends to indicate market tops. And since the March lows, valuations have started to drift away from fundamentals, but not enough to justify a bubble. For investors who have shunned the Nasdaq 100 they find themselves in a frustrating position, do they wait for a pullback that might never occur, or assuage FOMO (fear of missing out) and invest at higher valuations but potentially guarantee lower returns as a result — its an unenviable dilemma.
All told, this rally is still underpinned by strong fundamentals and I believe fears of a dot-com bubble are premature.
