The phenomenon called NASDAQ

The US technology index NASDAQ has achieved a highly above-average return of 34% so far this year and on Wednesday, 11 December, closed above 20,000 points for the first time in history. I believe that this year's very strong rally has been driven at least to some extent by the unprecedented investor frenzy surrounding the rapid development of artificial intelligence, and its impacts on economic growth in the long-term and the dynamics of corporate fundamentals – revenues, earnings and cash flow – respectively.

The current valuations – EV/Sales 5x, EV/EBITDA 23x, P/FCF 45x and P/E 42x – are, in my opinion, significantly overstretched and comparable only to the technology bubble of 2000. At the same time, it is also true that many investors have recently begun to question the importance of equity valuations, saying that we have entered a new extraordinary economic and market era. In other words, many investors now believe that this time is different, which is, in my opinion, the most dangerous sentence that investors can ever mention. I believe that it is precisely at such moments in the history of stock markets when the relevance of valuations for medium- to long-term expected stock market returns has been the highest.

As for the current record market capitalization of companies in the information technology sector and at the same time record equity valuations, I now hold the opinion that these market variables price in overly optimistic expectations for the coming years, regarding the dynamics of corporate fundamentals – revenues, earnings and cash flow – which, at the same time, are not very likely to materialize at the end of the day. The very strong growth of corporate fundamentals in the sector might indeed continue for some time yet, however if the capitalist market economy still functions at least to some extent, and I believe it does, then sooner or later the competitive forces in the information technology sector will inevitably cause the dynamics of revenues growth to slow significantly and profit margins to fall markedly, as will the average return on invested capital (ROIC) in this sector, at least as per the average company in the sector (Michael Porter’s Five Forces). On top of that, indeed, academic research and valuation practitioners have also showed that sustaining a period of very high growth usually proves to be extremely difficult if not impossible, because growth decay, i.e. growth mean-reversion, is on average a very huge challenge to overcome (McKinsey & Company, Valuation – Measuring and Managing the Value of Companies).

Within this base case expected scenario of mine of the future market development, it is also quite likely that companies from the information technology sector will gradually start reporting worse economic results than expected by equity analysts during the quarterly earnings seasons, or at least the magnitude of positive surprises on the top-line and on the bottom-line will begin to gradually fade away somehow. This would definitely cause a decline in market expectations regarding the dynamics of corporate fundamentals in the medium- to long-term horizon, and subsequently a significant decline in equity valuations as well, i.e. the equity valuations’ mean-reversion. That said, such a development of both key drivers of total equity returns – dynamics of corporate fundamentals and change in valuations – would present a significant headwind for the NASDAQ index performance going forward.

And that is why I currently hold a rather moderate investment view on the NASDAQ index, in terms of the expected average annual return over the next decade. On the other hand, of course, it is also true that equity valuations usually indicate almost nothing at all regarding the expected short-term market development in the next 12 months. And therefore the NASDAQ index could quite easily continue to grow significantly in 2025. However, the probability of this scenario being realized is below 50% in my opinion, and at the same time I have now a strong feeling that the probability is quite significantly higher than 50% that the NASDAQ index will have a weaker performance compared to the rest of the global stock markets in the course of next year 2025.