The Nasdaq Composite is up double digits year to date (41.9%), compared to a total gain of 35.2% last year. To sum up, in 2020 after the epidemic and the huge blow to the global economy, the global stock market rebounded strongly led by the U.S. stock market, i.e. not in an L-shape or U-shape as predicted by many academics and experts at the beginning of the year, and even by the end of the year, there was a blowout of small and medium-sized stocks. As an analysis of this phenomenon in 2020, there are various factors, such as market liquidity, Fed QE, various stimuli provided by Congress, strong economic recovery, and retail investors’ pursuit of small and mid-cap stocks, all of which have a superimposed effect. In this article, due to space limitations, we will only discuss two points: 1) what is the trend of the difference between the high valuation of these growth stocks and the low valuation of value stocks, and 2) whether the market will again be as many large institutions expect in 2021, and what is the possibility of more than 10% increase?
1) What is the likelihood that the market will rise by double digits for three consecutive years?
We first explore the second question, because this issue is actually very little controversy in the market, which tends to make investors lose due caution. The market discounts the future with rather brutal efficiency, and if we look at history, 3 consecutive + 10% returns are not common, and it is very difficult to surprise the market for three years in a row.
In the case of the S&P 500, for example, the index rarely achieves a third consecutive year of double-digit returns. Since 1958, the S&P has had 19 consecutive years of double-digit returns for two consecutive years (full-year data for the first year), but the index has produced positive double-digit returns for a third or more consecutive years in three periods (1963-1965, 1995-1999 and 2012-2014). The statistic from the historical data is that the probability of a double-digit return in the third consecutive year is very small indeed. The probability of an occasional double-digit return in two consecutive years is indeed relatively high throughout the cycle.
Based on the fact that both institutional and individual investors in the market are currently most bullish on the technology sector, we use the Nasdaq Composite Index as a proxy for the same analysis. The display reads as follows.
The number of times since 1972 that the Nasdaq Composite has experienced consecutive double-digit price returns (comparable data) for two or more years in a row, including this year, brings the total to 15. In the year following those 14 events, the probability that the Nasdaq will continue to rise is over 50%, at 57%. The average gain on a price basis (excluding dividends) was 10.4%. It is important to note here that there was a large spillover in some of the years of the 1990s, and the average was severely overstated. For example, the best return in 1999 was +85.6%; the worst was -39.3 % in 2000.
The times when the NASDAQ produced a third consecutive year of positive double-digit returns in four periods were as follows.
1978-1980: 1978 (+12.3 pct), 1979 (+28.1 pct), 1980 (+33.9 pct)
1991-1993: 1991 (+56.9 pct), 1992 (+15.5 pct), 1993 (+14.7 pct)
1995-1999: 1995 (+39.9 pct), 1996 (+22.7 pct), 1997 (+21.6 pct), 1998 (+39.6 pct) and 1999 (+85.6 pct)
2012-2014: 2012 (+15.9%), 2013 (+38.3%), 2014 (+ 13.4%)
According to the shown, three main findings we can draw.
First: similar to the S&P 500, positive double-digit returns in the third year of the Nasdaq Composite are not common. This is usually done against a backdrop of easing financial conditions and improving earnings, such as after the bull market of the 1990s or the financial crisis. However, as time passes, double-digit annual returns become more common as the economic cycle lengthens. So a big question mark for 2021 is whether even with a new administration in place, will there be any more stimulus packages?
Second: The Nasdaq has experienced more consecutive 3-year positive double-digit positive returns than the S&P 500, due to its greater use of highly innovative technology. Although sometimes unpredictable, technology companies tend to have higher beta, higher likelihood of earnings surprises, and build a strong competitive advantage when their products/services reach critical mass. In addition, the NASDAQ has a more dynamic indexing process because it includes companies that have not yet generated profits, unlike the S&P 500. This will allow some disruptive companies to be included in the index earlier, so they will not suffer the same lag time that the S&P 500 includes.
Third: Part of the reason the Nasdaq rose so strongly last year was due to the sharp sell-off in the fourth quarter of 2018 and the Fed Chairman Powell’s move to lower interest rates thereafter, and in 2020 the Nasdaq rises even further due to the Fed’s accommodative strategy and massive fiscal stimulus. But in 2021 and then again after the current second round of bailouts, it will become more difficult to get more stimulus programs. But given the severity of the latest recession, this is not impossible. The Federal Reserve last week signaled that it will keep interest rates near zero for the foreseeable future, helping to support equity valuations. This is especially true of the so-called high growth stocks that we commonly see.
Therefore, a comprehensive assessment of the market’s performance next year will largely come from how the market views economic growth and earnings of U.S. companies in 2022, but the Nasdaq market will again struggle to get a 10% return, especially at the moment are already almost perfectly expected future company earnings.
2. What are the causes of the high valuations of growth stocks and the drivers behind them?
When it comes to growth stocks, it is important to define value stocks. Value stocks are based on the value factor defined by Professor Fama of the University of Chicago, which is defined as buying companies with a low P/E ratio and selling short companies with a high P/E ratio. The performance of private equity funds that have practiced this strategy over the past four years has been a big disappointment. More typical ones, such as Warren Buffett’s fund, and even many quantitative funds invest based on the value factor, but of course the performance can be imagined. So on different occasions, it has been said that this era has become an environment that is not conducive to value creation. Why? Because intangibles have increased as a percentage of the valuation of fast-growing technology companies, thus making value investing obsolete.
Such a viewpoint is irresistible to young individual investors who have not experienced a stock market crash, and such a story has a simple and intuitive appeal. Evaluating tech companies on traditional P/E ratios does feel outdated. We’ve all seen how tech companies have changed modern life, from the way we’ve utilized ZOOM this year (by way of Zoom, actually) to the way we order food (from the couch). All of this combines to create an accessible and fascinating sentiment: traditional value investing has been challenging over the past decade because the market capitalization of tech companies is based almost entirely on intangibles.
From an accounting perspective, intangibles are immaterial or material assets that we can’t touch. They are a hodgepodge of brand value, customer loyalty, goodwill, innovation, and corporate culture. All intangible assets are unique and not directly comparable between companies.
For example, America Online accounted for $127 billion in goodwill when it acquired Time Warner in 2000, resulting in a large premium relative to Time Warner’s book assets. Today, the deal is widely seen as a failure, as the combined company wrote off $99 billion of goodwill in an impairment test in 2002. That may sound like a lot of money, but it’s only a fraction of the intangible value implied by the current market value of FAANG stock. Among these five companies, the average ratio of book equity to market capitalization is 8%, so they have few tangible assets, as shown in Figure 2. For example, Netflix has a market capitalization of over $200 billion, but only $8 billion in book equity.
If we do a strategy that is a Long/short Value factor, the annualized return is shown in Figure 3. We can clearly see that there was only a relatively short period of profitability throughout the last 10 years, with the majority of the time trending downward until a turnaround at the end of 2020.
For institutional investors, the change at the end of 2020 is a precursor to a possible structural change, which is likely to be reinforced by more uncertainty following the change of government between the old and the new.
To sum up, 2020 brings great uncertainty in the capital markets, and indeed gives many surprises. 2021 is not a smooth road to get excess returns.