Is the Nasdaq in a Reflexive Bubble?
The dogma of passive investing and the A.I. rush. Think Blockchain 50X.
Last week I wrote a small piece on the rush into A.I. — backed mainly from VC money. This was triggered by the launch of Chat GPT near the end of 2022, and by the effect the launch had on A.I-related share price valuations. The A.I. rush had begun then and there.
Today I will be digging deeper into the dogma of passive investing, the NASDAQ 100 constituents and their valuations, and investigate whether said index is in a reflexive bubble.
The theory of reflexivity was developed by George Soros and it is a framework for understanding far-from-equilibrium conditions in financial markets. Far-from-equilibrium conditions arise when positive feedback loops exist between prices and the fundamentals (that they are supposed to passively reflect).
Before we get to the A.I. bubble part of this post, let’s talk a bit about passive investing and its rise and rise.
“Passive” Investing
Nowadays, even the last market participant knows that passive investing is the way to go…
Some say they prefer passive because the efficient-market hypothesis (EMH) holds - which means no one can beat the market. Others are simply disillusioned with the performance of active management and just threw in the towel as the Nasdaq and S&P500 (“the indices”) continued to rally against all odds.
Well, I take offence with this intellectual dishonesty. Firstly, the market is definitely not efficient and instead of spending time to refute the EMH, for the sake of my readers I will cite the bullshit asymmetry principle1 and be done with it.
Additionally, I ask you, what merit is there to look at the “average” active manager and make decisions off of those findings? Actually, you aren’t even making decisions, you are looking at the results in hindsight and picking and choosing where you would rather be. Ridiculous!
Passive Management cannot be compared to Active Management, and should never be. We are talking about two completely different styles of investing, with different objectives.
Passive performance is what everyone likes to talk about when it’s going well, and lie to their friends that they never dumped their QQQ ETF when the market tanked in 2020.
Active is a whole other animal, it can be hell in fact.
If you are an active manager your investors will 1) Compare you to the indices when the indices are over-performing. 2) Say nothing to you when you are over-performing. 3) Reference the fees they pay to be long the SPY ETF when you talk about fees with them, and by the way they are never long the indices because they are either too expensive or it’s a recession. 4) When the markets are dropping they will call you 3 times a week asking you what risks do you see in the horizon, what the ultimate downside is and why are you still holding XYZ stock? 5) If the markets continue crashing they will come back to get their moral victory, and if markets bounce back they will either get lost for a bit or ask you why you won’t sell some on the bounce.
These “investors” will listen to you for hours talking about single stocks and their 5 to 10 year prospects, and they will be excited with you as long as the stock is moving up. On the first sign of weakness, they will come back to breathe down your neck until you have second thoughts and start doubting yourself and your strategy.
These same people are the people who will still compare you to the indices at the end of the year, even if you would have performed better if they hadn’t hijacked you. My point is: don’t talk about passive investing if you can’t even practice it yourself.
Now that I have concluded my mini rant, let’s have a look at the Nasdaq and how it returned almost 4.5X in the past decade.
The Nasdaq 100
Its top 20 constituents make up 62.5% of the index and they are concentrated in Tech and Semi names. I created the table below to give us a visual representation of the Nasdaq top 20 and how share prices have performed relative to Earnings per Shares (EPS) growth.
You will observe that some figures are negative like for Tesla, Intel and AMD which is because EPS is lower now than it was 10 years ago. This skews the Multiplier making it harder to make cheapness comparisons, but no one said this tactic is perfect.
For names like Amazon, which had faster EPS growth than Share Price Growth (i.e. it was more expensive then, relative to now), just look at the P/E figure to assess relative valuation.
We can easily see from the far-right column that most of these names are richly priced — potentially making them very bad investments in case something were to go wrong. —> “Business Risk” it used to be called, now it’s long forgotten.
Out of the top 62.5%, only 4% is unrelated to the technological revolution. This can only mean one thing — that being long the Nasdaq 100 is being long technology and innovation*.