It's been an impressive run, to say the least. Not only is the Nasdaq Composite (^IXIC 0.10%) up 37% year to date, as of Wednesday it's up 79% from its March low. And that's factoring in this week's weakness.
Stalwarts like Apple (AAPL 1.27%) and Amazon (AMZN -1.64%) have done more than their fair share of the heavy lifting, of course. Both boast market caps in excess of $1 trillion, making their market-beating gains this year a very big deal for the cap-weighted composite. Meanwhile, a handful of smaller names like Tesla (TSLA 12.06%) and Zoom Video Communications (ZM 0.05%) made an oversized impact with their enormous gains. Shares of the electric car company have soared more than 600% so far in 2020 because ... electric cars. Zoom Video's up on the order of 500% year-to-date because it helped employees work from home when organizations had little time to prepare for that contingency.
Image source: Getty Images.
Regardless of how it happened, the intimidatingly big gains leave investors in something of a lurch. Is there any room left for further upside, or has all the prospective bullishness been spent? In a more philosophical sense, will these bets on a post-COVID recovery pan out as hoped?
They most likely will, so no, it's not too late to buy if you're still mostly on the sidelines.
On the other hand, newcomers would be wise to tread carefully from here. Most of the low-hanging fruit has been picked. We're starting to see particular softness from the names, in fact, that would normally be pulling the Nasdaq higher with them.
The Nasdaq rebounds for all the right reasons
In late February -- when the coronavirus contagion become a clear threat to the entire world -- investors panicked. Fearing the worst, they sent stocks sharply lower. The Nasdaq Composite tumbled 30% from February's high to March's trough. That's when the world remembered capitalism finds a way despite any headwinds. As was noted above, the composite's gained 79% since then.
And for good reason. While not as healthy as year-ago levels, the U.S.'s third-quarter corporate profits were decidedly better than they were during the second quarter. They're projected to improve again for the fourth quarter currently underway as well, leading into further (albeit cooled) profit growth for 2021. The earnings trajectory ultimately dictates the long-term direction stocks take.
When the broad market is pushing valuation limits, however, the short run can cause ulcers. That's happening with the Nasdaq right now.
Fundamental numbers for the entire Nasdaq Composite typically don't exist, and even if they did you wouldn't necessarily want to use them. The smallest and newest of Nasdaq-listed stocks are often unprofitable, pre-revenue companies that could skew the data. The Nasdaq 100 Index may only reflect 100 of the Nasdaq's 3,500 or so listed names, but they encompass most of the exchange's aggregate market cap using the Nasdaq's most established companies.
Translation: It's more than an adequate proxy for the Nasdaq Composite itself.
And what that proxy is telling us right now is that these names aren't cheap. The Nasdaq 100's constituents are currently priced at 38.4 times their trailing 12-month earnings and at 32.0 times their earnings estimates for the coming year. For perspective, a year ago the Nasdaq 100's trailing price-to-earnings ratio was a rich-but-palatable 26.1.
Blame this year's biggest winners the most. The aforementioned Tesla has rewarded investors well this year, but it's hardly a bargain when priced at 160 times next year's estimated earnings. Zoom Video's trading at 132 times its 2021 projected profits. These companies may represent the future, but it could take years to produce the sort of earnings that make their present prices make sense. Much can happen in the meantime.
These steep valuation measures don't inherently mean a bear market looms. As was noted, while these stocks are expensive, earnings are growing and expected to keep doing so through next year. Most central banks and world governments are trying desperately to drive economic growth even before COVID-19 is eradicated. They'll probably succeed.
But we're still seeing hints and glimmers that the rally since March is running out of steam.
Take a look. Amazon may have led the charge out of March's low, but it's failed to make higher highs since September. Ditto for Microsoft (MSFT 0.37%), Facebook (META -0.52%), and Apple, for that matter. Microsoft and Amazon shares, in fact, are both knocking on the door of lower multi-week lows just days after the composite reached a record high.
Though not shown on the chart, Zoom Video and JD.com (JD 2.61%) are among this year's Nasdaq-listed winners, and they've suddenly taken a turn for the worse as well. While by themselves they can't inflict a great deal of damage on the composite, in the aggregate, these smaller names can still take a toll. They often feed on one another's strengths or weaknesses too and help set a marketwide tone.
No, the Nasdaq doesn't absolutely need Apple and Amazon and the other mega-caps -- or even all of its smaller listings -- to help sustain its march into record-high territory. It can sure be tough without their help, though. The fact that traders are now balking at the very names that helped lead the nine-month rally is a clear warning.
The takeaway
Don't misread the message. The economy should be stronger than it currently is a year from now. Stocks will probably be higher at this point in 2021 than they are at this time. A recession and its (usually) corresponding bear market have been partially averted. It's not wrong to step into new positions here, even if you missed this year's gains.
But it would be wrong to blindly plow into a hot name just because it's been hot of late. There's not only time to be patient with any new entries, but there's good reason to do exactly that.
