Adriaan Pask, Chief Investment Officer at PSG Wealth
The Nasdaq was up 26% mid-July since January 2024 and the S&P 500 index was up more than 18% over the same period. Both indices have been powered upwards by tech stocks like Nvidia, Microsoft, Alphabet, Amazon and Meta. However, things have changed quite dramatically over the last few weeks with both the Nasdaq and the S&P 500 index down [-13%] and [-8%] respectively since then, erasing more than $5 trillion in market capitalisation.
We’ve seen tech-stock bubbles before, most notably in the early 2000s. This time around, the markets’ meteoric rise has been on the back of investors betting big on the artificial intelligence (AI) ecosystem. Nvidia has been the poster child for this trade and its share price is up 288% over the last year up to mid-July 2024 – making it the world’s most valuable company with an eye-watering Price-to-Earnings (PE) multiple of 70 times at that point. Since then, Nvidia has lost almost 30% of its value in the span of two weeks.
The P/E ratio serves as a proxy for the market’s assumptions about a company’s long-term growth rate. For instance, a P/E of 5 suggests a 5% annual growth rate, which is modest. Conversely, a P/E of 70 implies a 70% annual growth rate. That would mean that Nvidia’s market capitalisation will be larger than the GDP of a lot of countries in a decade if it keeps growing at the current rate. This is not realistic.
Given the above, we believe we are currently in a tech-stock bubble that may be on the verge of bursting. Although it’s challenging to determine our exact position in the cycle, the indicators are becoming increasingly evident. One reason we see these technology bubbles form is the inherent uncertainty in the sector. There’s often little concrete data for investors to rely on for accurate future projections. Big ideas in tech, especially in areas like AI, capture our imaginations and are heavily marketed, which can cause people to get overly excited. This is not to say that AI is a temporary or insignificant technology, on the contrary, it will be very significant. However, many people don’t fully understand what AI is truly about, beyond some basic concepts. This lack of deep understanding, combined with the hype, creates uncertainty.
Therefore, the bubble we are referring to is not in the technology, but in the market’s valuation of the tech companies that create this technology. It is possible to have substantial and transformative growth in technology that changes consumer behaviour, similar to the introduction of the internet during the dot-com bubble. While the internet’s impact has indeed been profound, the initial valuations were overly inflated.
The problem lies in the market’s focus on immediate, first-order benefits without considering the deeper, second-and third-order effects, where we believe the real value lies. This tendency to focus on immediate gains can lead to overly rich valuations, which is a characteristic of a bubble.
Looking at the dot-com bubble example, investors were piling into either the infrastructure or the software around the internet and computing, as well as dot-com companies specifically. But the biggest beneficiaries ended up being the companies who could harness the power of the internet into their business models. Companies like Meta and Google are prime examples of these winners.
Considering Nvidia against this backdrop, you realise that it is priced for perfection and that no ‘margin of safety’ exists for the share. No company is entirely immune to competition or regulatory scrutiny, yet Nvidia’s pricing reflects neither. Only growth is factored in, with an unrealistic assumption of indefinite sustainability.
Currently, these valuations are just too stretched for safe investing. Acknowledging the excitement surrounding this technology is crucial, as it often leads to overestimation. It’s important to recognize that more research is needed to accurately assess these businesses’ true value, as current information is often insufficient. This lack of clarity forces investors into uncharted territory, introducing additional risks. Keeping these risks in mind when evaluating the market is vital. Unfortunately, a common issue in markets is the tendency to rely on past returns, which can be very risky.
This mindset can lead to the hope of achieving similar returns, potentially overlooking the associated risks. Be mindful of these risks and avoid feeling pressured by enticing opportunities. It’s unnecessary to assume the high levels of risk currently prevalent in the market.
It is also important to remember that we are not deprived of investment opportunities. There are many great businesses that are offering 10% earnings growth per annum, high single-digit dividend yields and robust balance sheets. These companies’ proven business models provide safer paths to achieving your financial goals. There’s no need to chase speculative investments that could end poorly.
ENDS
