Is NASDAQ really overvalued in 2020/21
We are going to analyze NASDAQ from an original perspective.
Valuation theme
NASDAQ has often been talked about during the pandemic. It showed an extreme behavior by not only bouncing back to its previous highs, but even stretching further out, once the monetary stimulus by Feds was applied. The question naturally arises if we are due for a NASDAQ correction. I will try to provide a very different perspective to NASDAQ valuation, which neither looks at company’s fundamentals, nor the market sentiments. It does not even take into account the standard notion of trends, or charts. We will use a single chart, but only to provide intuition and to demonstrate a quantitative degree of over/under valuation.
Single point of analysis for this article. Growth. What if we could analyze the past growth of NASDAQ to come up with a proxy for how the technology sector has been growing in the economy. Demonstrating with an example, we will invest a 100K into NASDAQ at the beginning of the year 2010, just coming out of the last recession. And we will track that 100K as the NASDAQ , or Hi-Tech sector grows over the next 10 years.
Evolutionary path of NASDAQ
Lets get to some analysis of NASDAQ progress. Here is a snap-shot of how we are going to talk about it.
The blue line shows the NASDAQ, while the orange line, samples a point from the index every quarter, or once every 90 days. I choose this quarter based sampling because in some ways it represents everything that happens in a quarter, and is a more representative measure of evolution as a whole. The important line in the graph is the green line. The green line is plotted as a fixed rate of growth. What if my 100k has grown at a continuously compounded rate of 2.5% a quarter. 2.5% a quarter, roughly translates to 10% a year (slightly more than that) which is the long established rate of stock market growth in many large indexes. So what is the green line showing ? The fact that the general market has lagged NASDAQ by quite a bit. The two exponential growth trajectories, one of NASDAQ and the other of fixed 2.5%-per-quarter growth, are quite divergence. Let me take you to the next figure, where I up the compounding rate to 3%-per-quarter, or roughly 12% a year.
We can see the green line creeping up. And even broadly aligned with the index line, in the beginning phase, from 2010 to around 2013. What happens next. Can I match the green line, to be more resonant with the orange/blue. Lets see. Lets up our compounding to 3.5% a quarter, which translates to a monstrous 14%+ rate over the year.
As we see, the green line has really crept up to the index line. But would we visually say that they are aligned ? Up until 2016 it quite seems so. Beyond that, the green almost continually lagged the index. So whats next. Can we push it further to improve alignment. Lets make, what potentially could be our final attempt at matching the index. Remembering, matching the index means, in some sense, we are inferring, the broad progress of technology as a function of time. Very important to keep in mind. Since we are very close to converging to index, I will decrease my rate increment from 0,5, to 0.025, that is half of the original. So instead of showing you a plot for compounding of 4%, I will show you a plot of compounding of 3.75%. Lets have a look.
Voooow !!!!! The green has literally merged into the index, for the most part. It hugs the index until 2014, dips a little below from 2014–2016, then springs up from 2016–2017, and this back and forth continues down the time axis, until we hit the Corona virus meltdown in early 2020, after which the index spikes sharply up. This up and down is very important. Because what that signifies is that the index line is randomly swinging above and below a certain average rate. An average rate, that seems very close to 3.75% a quarter. If not exactly 3.75%, we can see that it is very close to that number.
So what do we see here. We see that if we are to believe the figure above, then the rate of high-tech progress, and the market value of its products have been growing at an average rate of 3.75% a quarter, since the last decade. If NASDAQ goes well above this value, there is a hint of overvaluation. If NASDAQ goes way below, there is a cause to suspect undervaluation. So where does it leaves NASDAQ as it currently stands….. Drum roll………..
Current state of affairs
Here is the current result of orange vs green line, in the Dec of 2020. (I am using the subsampled orange points, to make it independent of a particular day)
Result of 100K in NASDAQ : 599K
Result of 100K in 3.75% Compounder : 486K
Note : I am only listing results to the nearest 10,000
There you have it !!!! NASDAQ index is above its historical rate of growth. The overvaluation can be computed by taking the difference of 599K and 486K and taking a ratio with the lower of two. It comes out to be around 23%.
Takeaway
I provide a look at historical evolution of NASDAQ. The core idea of the analysis was to provide a number, that summarizes the progress of NASDAQ over the last decade. Since the index fund QQQ had only been in existence for a while before the dotcom crisis, the historical data here is scant. The key point to impress upon, however, was that the NASDAQ has shown a surprisingly consistent gain of close to 3.75% a quarter. If past is any clue to the growth of technology sector within the broader US market, we can infer that the valuation of NASDAQ can be established from the central 3.75% a quarter growth line. Using that as reference, the current NASDAQ looks overvalued, not by huge stretch that some analysts might point out, but by a very ‘reasonable’ margin of 23%. This in in sharp contrast to the different doom and gloom scenarios we hear about in the standard finance. If we are to put a trust in growth trajectory and the hypothesis of technology sector growth being a tad above the broader market (3.75 vs 2.5 a quarter), we could be tempted to dial down on our NASDAQ allocations, in accordance with the overvaluation percentage.
