Nasdaq 2022: Is history repeating itself?

The tech-focused Nasdaq Composite is down 31% year-to-date, and investors fear the sector is poised to follow the same pattern as when the dotcom bubble burst in 2000-2002.

We look at the evidence for the old adage “this time it’s different”.

Turning

The most obvious red flag for weakening tech sentiment is special purpose acquisition companies (SPACs). These financial vehicles raised billions when interest rates were low, aiming to acquire or merge with a listed company within two years. Even Donald Trump got in on the action. Now SPACs are being hit by falling valuations and lack of liquidity or funding – and some of their most prominent promoters are currently throwing in the towel.

The bubble’s previous implosion had more to do with accounting scandals (Enron, Worldcom), the use of financial shenanigans (such as off-balance sheet items) or the excessive use of derivatives (qualified at the time as “Weapons of Mass Destruction” by Warren Buffett).

There are many unprofitable companies that are likely to remain so for some time, some for temporary reasons (due to the higher risk of recession), but others for more structural and valid reasons (the inability to prove that their business model creates value, because the return they generate does not cover their cost of capital).

Such was the case in 2000-2002 when a company like Pets.com was liquidated a year after going public.

But a more fundamental reason to continue the market correction would be a downward revision of earnings estimates.

All eyes on the winnings

So far, the main driver of the market correction has been a sharp decline in valuation multiples, driven by rising interest rates and fears of a subsequent recession.

But earnings estimates have held up well.

There have been a number of significant earnings warnings recently, such as Instantaneous, Focus on video communications Where Interactive Platoonwho were the poster children of the pandemic world, but so far these seem more idiosyncratic than revealing larger issues.

This might not last forever and could lead analysts to lower their earnings estimates going forward. Currently, the Nasdaq Composite Index is trading on a price/earnings ratio of 35x earnings, which is still quite high compared to global and US markets (which are currently trading on a P/E closer to 16x, in line with the story).

One of the main risks identified by investors would be that of a recessionary scenario, where the greater the downward revision in earnings, the lower the index would fall.

Based on the latest comments from Fed Chairman Jerome Powell, this scenario is increasingly likely. The conclusion here would be to wait and see how earnings perform over the next few quarters before you start looking for opportunities. The third-quarter earnings season is about to begin, with corporate America beginning to report in October.

Some lessons from history

Investors might also consider technical factors. The index fell below its 200-day moving average at the start of this year.

In 2000, when this happened, the index fell again.

However, graphical analysis is not infallible. The occurrences where the two lines intersect are numerous, such as in the fourth quarter of 2018, during the summer of 2015, during the euro crisis of 2010-2012, and of course the financial crisis of 2008.

All of these episodes were triggered by different macroeconomic events, but none generated a market drop of the magnitude of the tech bubble implosion of 2000 – one reason for this could be that central banks were leading a very accommodative monetary policy and kept interest rates low.

This difference could further prolong the current slowdown.

Evaluation is key

As an investor, if you try to time the market and predict when the Nasdaq Composite Index will bottom out, you are playing a dangerous game.

Market timing isn’t much of a Morningstar mantra, as our data shows time and time again that it leads to lower returns for the investor.

On the other hand, if you are focused on the long term and can withstand market volatility, your main concern should be to buy quality assets and pay attention to valuation.

In this regard, market volatility is not a problem. It is true that it is difficult to take virtual losses when you see the price of a share fall another 30 or 40%, but if your asset is of quality, this should not bother you too much.

Focusing on valuation is the primary means that will help you generate decent returns and control risk.