NASDAQ 100 Back to Fair Value: Here’s What Happens Now

Summary

• It took 11 months, but the NASDAQ 100 (NDX) bubble has finally deflated. The index is now trading at fair value thanks to the pressure of rising rates.
• For all the talk of recession, the NDX has yet to start pricing in any risk of recession.
• If a recession comes, the NDX could fall by another quarter or more.

Market Implications

• We expect the NDX to trade in a range for now, and trend downward if the 10-year Treasury yield rises further.
• It will fall sharply if either earnings momentum slows or the economy falters, whether because of weaker labor market or consumer spending.
• We are underweight equities in our overall asset allocation framework.

TLDR^[1]

Last week’s earnings tech-wreck among the NASDAQ 100 (NDX) megacaps has raised questions about NDX valuation and outlook from here. Below are some quick answers.

Analysts are looking for earnings per share to rise about 9% in the coming year relative to 12-month trailing EPS of $483. That is rather more reasonable than the 18% they were forecasting in early 2022.

According to our valuation models, the NDX is now trading at fair value based on projected earnings. A few days ago, when we started this analysis, it was 6% overvalued! We expect it to trade in a range pending significant new information about earnings or the economic outlook.

Seven megacap stocks – think Apple (AAPL), Microsoft (MSFT) and the like – were clear drivers of the massive rally in the NDX through the end of 2021. But surprisingly, they have simply tracked the broader index in the 2022 selloff. We expect that will continue to be the case unless there is a recession.

We attribute the 34% decline in the NDX in 2022 almost entirely to higher rates and a higher discount rate applied to future dividend cashflows.

So far, the market is not pricing in the prospect of recession. Should a recession happen, history suggests earnings can drop 20-40% and take several years to recover to pre-recession levels. That haircut could cause the NDX index to drop another quarter or more.

A recession is not inevitable. But we also see risks tilted to the downside. Either slowing earnings momentum or economic weakness – e.g., sluggish labor market or slower consumer spending that imply lower earnings – could hit the NDX hard. In any case, we see little prospect of a sustained equity rally as long as the Fed is raising rates.

NDX Is at Fair Value

Over time, the key driver of equities is earnings and earnings expectations (Chart 1). Thanks to the extraordinary circumstances of the pandemic earnings, growth accelerated sharply after the 2020 election. But the NDX simply powered far beyond even those rising expectations.

The selloff in 2022 has effectively re-aligned the index with earnings. Taking forward earnings as our benchmark, we see the NDX is now trading at fair value. Just a few days ago when we started this analysis, it was 6% above fair value!

The venerable price/earnings ratio also suggests the NDX is trading near fair value (Chart 2). The P/E based on forward earnings is roughly in line with or slightly above the 2014-18 level and in line with the years before Covid.

Putting these pieces together, we expect the NDX to trade in a range pending significant new information, whether on earnings expectations or the economic outlook.

What the Megacaps Did and Did Not Do

The NDX index contains 100 stocks, but six of them accounted for 54% of the index as of the end of October (Table 1).^[2]

Those six companies played an outsized role in the NDX rally since 2016, and especially during the pandemic (Chart 3a). Between 2006 and 2021, the combined marketcap of the megacaps grew 2.5 times more than the NDX ex megacaps.

But, surprisingly, during the 2022 selloff, the megacaps and NDX ex megacaps have tracked each other lower. Further, the decline the NDX has mirrored the rise in the 10-year Treasury rate.

Our take here is that the NDX index (and its megacap and ex-megacap subindices) has simply devalued due to a higher discount rate being applied to future cash flows.

Whether the megacaps continue to trade in line with the broader index will depend on whether their collective earnings power strengthens or deteriorates relative to the rest of the index. Or put differently, whether the advantages they gained in recent years are structural and unlikely to change much or not. We think they will retain that advantage for now but could lose some of it in a recession scenario.

What a Dividend Discount Model Tells Us

In theory the value of a stock or stock index is the present value of future dividends. Theory aside, a dividend discount model can go far in explaining what has happened to the NDX in 2022 and how it might fare in different scenarios going forward.

We generate dividend cashflows assuming a 25% payout rate and an 8% annual growth rate. The internal rate of return of this stream based on the 2021 yearend NDX value of 16,320 is 7.5%. Rerunning the analysis based on the current index value of 10,760 yields an IRR of 8.4%, 90bp higher.

Earnings expectations for the NDX have dropped slightly since the beginning of the year, from an EPS of $560 to $530. Using this latter value as the starting point, the IRR fall 12bp to 8.28%, or about 5% in index value terms.

Summing up, the higher discount rate accounted for 95% of the 2022 decline in the NDX.

An increase of 90bp in the discount rate may seem low given that the Fed Funds rate and 10-year Treasury yield are 3.75% and 2.6% higher. But think about it this way.

In this framework, we are focusing not on the 10-year yield where it was at the beginning of the year (1.5%) or currently (4.1%), but rather the long-term average yield. Given that the equity risk premium in recent years has been around 5.5% and the 8.4% IRR from our model, that implies a 10-year Treasury yield of 2.8%.

We can go further and suggest that this is the market implied 10-year Treasury yield as inflation falls (eventually) and the Fed’s policy rate and yields decline.

What About the Recession Scenario?

This analysis essentially assumes that the NDX index has repriced to reflect a higher rate environment, and that it now resumes a course of normal moderate growth off from a lower base. One less welcome implication is that it could take 6-7 years to recover to early 2022 levels unless some catalyst sparks an extraordinary and sustained burst of earnings growth.

A more unsettling implication is that equites today are simply not pricing in any likelihood of recession. If the economy does go into recession, earnings and equities could fall precipitously from here.

It has been well over a decade since the last recession (not counting the 2020 Covid collapse and recovery), so we compiled some facts and figures about the S&P 500 (SPX) since 1980 (Chart 4, Table 2).

During recessions, earnings take a hit, ranging from 85% of the pre-recession peak down to 50%. The SPX typically drops to 60-85% of the pre-recession peak. More telling has been the extended time it took the index to recover to the pre-recession level. After the 2000 and 2008 recessions, it took 6.5 years to recover – 2000 was a bubble situation and 2008 was a major financial crisis.

We base this analysis on the S&P 500 because we do not have earnings history for the NDX before 2002. But we note that the NDX has been more volatile. After the 2000 bubble, NDX index sank to less than 20% of its 2000 peak level in October 2002 and took more than 16 years to fully recover. During the 2008-09 selloff, the NDX dropped to less than 50% of its 2007 high (or 23% of the 2000 high).

(The recovery time was much shorter in the 1980 and 1989 recessions. In 1980, the market was already severely depressed due to high interest rates and the 1979 oil price crisis; in 1989, the market was still dealing with a hangover from the October 1987 crash and the imploding thrift industry crisis, and hence lagged rising earnings during the period. Note, however, that earnings fell to 61% of the pre-recession level.)

Looking Ahead…NDX Could Fall by a Quarter or More

Given the Fed’s hawkish stance against inflation a recession within the next year is a definite risk.

Obviously, we do not know what that next recession will look like – whether it is shallow and employment remains high, or if triggered by some kind of major crisis, whether financial or geopolitical and is deep; or if it is just ‘normal’.

Whatever the cause, if unemployment rises significantly, we can expect earnings to drop sharply. Given that the selloff to date in the NDX reflects primarily higher rates and no provision for a possible recession, we would expect a further significant fall in the index.

Absent extraordinary Fed monetary and government fiscal policy similar to the Covid stimulus, history suggests we could reasonably expect the NDX to fall to less than half its early 2022 peak, or around 8,000. Using our dividend discount model and entering an earnings scenario similar to the SPX experience of 2000 and 2008-09 experience, we derive an NDX value of 8400. In a more severe downturn or crisis, the NDX could fall by a third or more from present levels.

Government Support (or Lack Thereof) Is Key

The caveat ‘absent extraordinary’ government policy is significant. If the government were to aggressively step in to cushion the economy, any recession-related selloff will soon reverse course. Likewise, if the political environment is such that the government fails to take even standard stimulus steps, the fallout would likely be worse.

How the government support variable plays out will depend on the facts and circumstances at the time. That aside, it is anyone’s guess now.

Concluding Remarks

To reiterate, the NDX has returned home to fair value. As long as the Fed is raising rates, we see little prospect of a sustained rally. The risks are weighted to the downside.

The megacaps travails aside, the 3Q earnings season is demonstrating that many corporates retain significant earnings power despite rising rates – although projected earnings growth rates have eased from the up teens to a still – respectable high single digit level. The labour market is demonstrating that the US economy remains robust despite rising rates. Consumption spending continues to be robust despite rising rates.

The primary casualties so far have been bonds and equities. Treasuries are down 14.4% year to date under the dual pressures of inflation and the Fed, while equity valuations have only limited ability to withstand the discounting power of rising rates. We expect equities and the NDX to trade in a range and trend downward if 5- and 10-year Treasury rates keep rising.

The next big leg down for equities will come if either earnings momentum slows or the economy shifts downward, due to a faltering labour market or slower consumer spending. The market might initially rally on hopes the Fed pauses or even cuts rates. But the likely impact on earnings will soon dominate.

The good news is that there is still time to talk about ‘if’ as opposed to ‘when’. That may be why equities have not yet started to price in a risk of recession.

[1] Too long; didn’t read!

[2] We did not include Netflix (NFLX) as it is less than 1% of the index. Even at its height NFLX was notable more for its extraordinary growth rate than absolute size.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)