The Nasdaq is getting crushed this year, and it's causing plenty of fear among investors. The index is moving from correction to crash territory, as it's down 25% so far this year. It's natural for confidence to get shaken by big losses, but these are actually the times when the best deals become available. Investors have to take emotion out of the equation and determine if it's time to scoop up Nasdaq stocks at a discount.
What's going on with the Nasdaq
This correction has followed a classic and fairly predictable pattern. Stock markets have always followed long-term upward trends, but those paths are not smooth. They go through cycles over time as markets rise and fall due to short-term global economic conditions. Valuations rise and fall with factors such as interest rates, economic growth, and investor risk appetite. However, growing cash flows drive stock values higher over the long term.
The stock market crashed at the start of the COVID-19 pandemic as economic activity ground to a halt and uncertainty hung over everything. After a few weeks, businesses and investors began to make sense of the new conditions and identify opportunities. Low interest rates and attractive valuations pushed capital back into the stock market, and it disproportionately went to tech stocks that were less disrupted as people stayed at home. This combined with a renewed appetite for risk as investors rode momentum to the highest valuations since the dot-com bubble.
Those sorts of valuations aren't sustainable without incredible economic growth and low interest rates. That's exactly why rate hikes by the Federal Reserve and slowing economic growth are forcing investors to be more diligent about pricing and allocation. Last year, there was a big sell-off in stay-at-home stocks like Zoom Video Communications and Peloton Interactive. This year, a larger rout has impacted stocks across numerous sectors. Growth stocks with aggressive valuations have been hit the hardest, while value stocks and dividend payers have held up relatively well. The Nasdaq skews more heavily toward tech stocks, so it's getting hit harder than other indexes.
Another noteworthy trend that's emerged is concentration. The largest companies in the Nasdaq currently account for a larger percentage of its total market cap than usual. The 10 largest stocks make up more than 50% of the index, and the top five are worth nearly 40% of the market value. A smaller number of businesses now exert a larger influence over the Nasdaq as a whole. This is even more relevant because these companies bear many similarities that cause the stocks to move in tandem. That adds to the volatility that investors are seeing right now.
The 10 largest stocks in the Nasdaq are:
- Apple (AAPL 1.01%)
- Microsoft (MSFT 0.58%)
- Amazon (AMZN 1.63%)
- Tesla (TSLA 1.37%)
- Alphabet (GOOGL 5.32%) (GOOG 5.34%)
- Meta Platforms (META 2.88%)
- Nvidia (NVDA 2.40%)
- Pepsi (PEP -0.03%)
- Broadcom (AVGO 2.06%)
- Costco Wholesale (COST 0.58%)
It's clear that many of these are subject to the same market forces that can combine to increase losses.
Where does the Nasdaq go from here?
Now that the Nasdaq is down 25%, is it a strong buying opportunity, or a value trap that will lead investors further down? The answer completely depends on your investment time horizon and risk tolerance.
Unless the global economy ceases to grow for the long term, I fully expect major stock indexes to deliver positive returns over any extended time frame. However, that might not be much help for the next few months. It's fair to expect more volatility in 2022, and the Nasdaq could fall significantly further before it returns to growth.
Unfortunately, most of the factors that are pushing the market lower are still in play. Interest rates are rising, and they are expected to continue rising for the rest of the year. The first-quarter earnings season is almost completed, and corporate forecasts didn't give Wall Street much confidence. Real GDP fell in the first quarter, sparking fears of economic slowdown, and the next update on economic growth isn't due out until July.
With all of that negativity in the background, stock valuations still haven't swung into must-buy territory. Most of the largest Nasdaq stocks still haven't fallen below their pre-pandemic valuations based on price-to-sales and forward price-to-earnings ratios.
If valuations were at historically low levels, then the Nasdaq would be a no-brainer, but that's not the case. Instead, it's hard to see the catalyst that turns the market around over the next few months.
All that said, long-term investors shouldn't really care about where the Nasdaq goes over the next six months. History shows that a diversified basket of stocks is nearly certain to rise over any 10-year period. If many of today's tech leaders continue to expand sales and profits, then the index should rise. If you were thinking about buying a Nasdaq index fund for your retirement account, then it's only become more attractive now that it's 25% cheaper.
If your goal is to achieve diversified long-term appreciation, then it's definitely safe to invest in the Nasdaq right now. If you can't handle the volatility that's likely over the next few months, it's best to stay away or allocate to bonds.