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Editor’s Note: This column first appeared in TradeSmith Decoder.
As of the Jan. 27 close (last Friday), the Nasdaq 100 was up more than 11% for the year. That counts as the best January start for the Nasdaq since 2001.
Good news for the bulls? Not exactly. See if this feels familiar:
- In 2000 — the year the dot-com bubble popped — the Nasdaq 100 finished the year down 39%.
- In January 2001 — the month that echoes this one — the Nasdaq surged to a 10.7% gain.
- And yet by year-end 2001 — in spite of the hot start — the Nasdaq declined 21.05%.
- Adding insult to injury (for bulls), in 2002 the Nasdaq declined 31.53%, its third brutal down year in a row (and a final wipeout event for those who “bought the dip” until all their money was gone).
If the pattern holds, then, the Nasdaq’s current 11% surge is an omen, not an encouragement. If 2022 is analogous to 2000… and 2023 is starting off like 2001 (with a face-ripping tech rally)… that implies 2023 could finish like 2001, i.e., down more than 20%.
Then, too, rallies with a feel of white-hot frenzy to them tend to happen in bear markets, not bull markets.
Equity bull markets are characterized by sustainable uptrends with low-to-moderate volatility. A truly great bull market will percolate like a coffee pot as prices drip, drip higher day after day. (This is what we saw with big tech in the 2010s).
Upward price movement in bear markets, in contrast, tends toward extreme volatility and FOMO (fear of missing out). The violent short squeeze and the “dash for trash” — when speculative junk names get bought en masse — are also bear market hallmarks.
While such moves give comfort to bulls, they tend to portend lower prices ahead, not higher ones.
With all of that said, the past is not the future — as the boilerplate disclaimer says, “past performance does not guarantee future results” — and there are differences between 2001 and 2023.
Unfortunately for the bulls, those differences make the 2023 outlook even worse, in our view.
Expensive Cash Flows and a Hostile FedA bull who takes issue with the 2001-2002 comparison might argue that the dot-com bubble was chock full of profitless companies — whereas today’s tech giants are gushers of cash.
This is true and a fair point. The dot-com bubble was wildly unprofitable, and the likes of Apple, Microsoft, and so on are cash flow juggernauts.
But in counterpoint to the profitable big tech argument, one could argue (and we do in fact argue) the cash flows of big tech are already priced in via valuation multiples that are still way too high.
It doesn’t matter how profitable Apple is if the earnings are too expensive: Paying too much for a cash-rich stock, in valuation terms, is like paying $10 million for a luxury rental property that brings in $10,000 per month. What you get isn’t worth what you paid… and the next buyer may be inclined to pay far less for that same stream of earnings.
Then, too, small-cap stocks today could give the dot-coms a run for their money, in terms of shocking levels of non-profitability.
“Approximately 40% of the companies in the Russell 2000 Index did not generate positive earnings over the prior 12 months as of March 31, 2021,” says a report from Eagle Asset Management, which goes on to argue that “a large portion of the [Russell 2000 small cap index] is nothing more than publicly traded venture capital.” The bulls should also consider this: In 2001 (year two of the Nasdaq’s horror show trifecta of declines) the Federal Reserve was actually cutting interest rates… whereas in 2023 the Federal Reserve is still hiking interest rates.
The Fed began cutting interest rates toward year-end 2000 as the Nasdaq imploded. By year-end 2001, the effective federal funds rate (a tracking measure for the short-term interest rate) had fallen all the way from 6.50% to 1.50%… and the Nasdaq declined 21.05% that year anyway (with a worse year to come in 2002).
Some might argue the terrorist attacks of Sept. 11, 2001, played a role in the Nasdaq’s sharp decline of that year — but it wasn’t a performance factor by year-end, given that the Nasdaq was higher on Dec. 31, 2001, than it was on Sept. 10, 2001 (the last day of trading before the attacks). So if the Nasdaq fell precipitously in 2001 even with the Fed cutting rates with abandon (going from 6.50% to 1.50%)… how much harsher might the outlook be with rates continuing to rise in 2023 (we still don’t know where the Fed will stop, which depends on the strength of the labor market) and then staying high?
Not to mention that the lagged monetary effects of the most aggressive hiking cycle in half a century (2022) are yet to be felt… or that the stimulus cash still being spent down by consumers is likely to tap out by this summer… or the fact that inflation is likely to get “sticky” again when it hits 3% or 4%.
From 10% Nominal to ZeroHere is more food for thought:
- For the fourth quarter of 2022, real U.S. GDP (the primary measure of U.S. economic growth) came in at 2.9%.
- The “real” in real GDP refers to the fact that the numbers are inflation-adjusted. Nominal GDP, in contrast, is the number without inflation taken out. (Think of it like this: If your employer gives you a raise of 10% but inflation is 4%, your “real” raise is 6% and your nominal raise is 10%.)
- As such, if real U.S. GDP was 2.9% in a quarter when inflation was in the 6% to 7% range… that implies that nominal (non-inflation-adjusted) U.S. GDP growth was in the vicinity of 10%!
- We know in retrospect, via corporate earnings calls and general earnings trends over the past year, that many U.S. companies actually benefited from inflation because they were able to pass higher prices to consumers, often in excess of their higher costs.
- So what happens, then, when we get into the grind of a real recession (deliberately caused by the Fed staying “higher for longer”) and nominal GDP growth goes from 10% all the way down to zero… even as the corporate earnings lift from inflationary pricing power disappears?