After the first full week into 2024, market dynamics are looking far different than in 2023. After the first five trading sessions, the Dow Jones Industrial Average (Dow) was down 0.6%, the S&P 500 fell 1.5%, and the Nasdaq Composite was down 3.3%.
Yet over the last five years, the Nasdaq is up 115.5%, higher than the S&P 500's 85.5% gain and dominating the Dow's 59.9% rise. But the S&P 500 and the Dow could easily beat the Nasdaq in 2024 for one simple reason. So the billion-dollar question is: Is the market's behavior in the first week a forewarning for what's ahead?
Image source: Getty Images.
Multiple expansion drives the Nasdaq's premium valuation
It's been a good five years in the stock market, even when factoring in the brutal COVID-19 sell-off and the 2022 bear market. The problem is that stock prices have grown at a faster rate than earnings in all three of the major indexes.
Since detailed index data can be hard to come by, we'll use the next best thing -- the largest exchange-traded funds (ETFs) for each index.
|
Fund |
Current P/E Ratio |
3-Year Average P/E Ratio |
5-Year Average P/E Ratio |
Current Premium To 5-Year Average P/E Ratio |
|---|---|---|---|---|
|
Invesco QQQ Trust (QQQ +1.30%) |
34.4 |
30.7 |
29.1 |
18.2% |
|
SPDR S&P 500 Trust (SPY +0.80%) |
24.4 |
24.2 |
23.9 |
2.0% |
|
SPDR Dow Jones Industrial Average ETF (DIA +0.69%) |
25.4 |
21.3 |
20.6 |
22.8% |
Data source: Market Chameleon.
As you can see in the table, the price-to-earnings (P/E) ratio of the Invesco QQQ Trust, which targets the 100 largest stocks in the Nasdaq Composite and practically mirrors the performance of the index, has ballooned to 34.4 -- significantly higher than the three-year and five-year averages. Meanwhile, the S&P 500 is still trading around its average valuation over those intervals.
The Dow is trading at an even larger premium to its five-year average than the Nasdaq. But there are a few reasons for that.
First, Salesforce, Amgen, and Honeywell replaced ExxonMobil, Pfizer, and Raytheon Technologies (now RTX) in the Dow in 2020. The move essentially tipped the Dow slightly more toward growth and away from value. Second, tech stocks have gone on a big run, such as Microsoft (MSFT 0.54%), which has a high 35.7 P/E ratio. Microsoft is currently the second highest-weighted stock in the Dow behind UnitedHealth Group. But five years ago, Microsoft was barely over $100 a share and was more of an average-weighted holding.
Despite its valuation expansion, the Dow is trading around the same multiple as the S&P 500, and both are far less expensive than the Nasdaq.
But does the Nasdaq deserve a premium valuation?
Not long ago, big tech stocks like Apple and Microsoft traded around the same P/E ratio as the S&P 500, or even at a discount. But there's a good argument that these companies, and the other mega-cap tech stocks, deserve a premium valuation given the strength of their balance sheets, fundamentals, wide moats, cash flows, brand power, and overall increased relevance in the modern economy. But what about the rest of the Nasdaq? What happened that made growth stocks so much more expensive than in the past?
There are many ways to address these questions. But my personal belief is that investors are pulling forward future earnings estimates.
Growth investing centers around the willingness to pay a high price for a company today, hoping it becomes much bigger. It's essentially betting on the future earnings and cash flows of a company. If the earnings growth of the Nasdaq, on average, is faster than in the past, then it would be a good reason to pay a higher multiple for growth stocks.
Trends like artificial intelligence (AI), cybersecurity, cloud infrastructure, and more could accelerate earnings and make many of today's currently expensive growth stocks look far cheaper in a few years. It's a speculative bet. But if it's true, then the Nasdaq really does deserve a higher-than-historic valuation. And investing in an ETF like the Invesco QQQ ensures a diverse portfolio and exposure to multiple breakthrough solutions.
The pitfalls of overexuberance
Getting fixated on the prospect of future earnings and sustained high growth can lead to drastically overpaying for a company. No matter how exciting an opportunity is, there's simply no telling if all will go according to plan, what the broader economy will do, what competition will bring, and the effect a slowdown on growth will have on projections.
An example from 2023 is Enphase Energy (ENPH +10.79%), which was one of the poorest-performing stocks in the whole S&P 500 last year. Enphase is mainly a residential solar company that makes inverters, energy storage solutions, and other aspects of the solar energy system (not the panels). It had been on a torrid run, growing its top line while sustaining incredibly high gross margins. There seemed like no end in sight, and the stock reached a nosebleed valuation.
It all came crashing down last year as high interest rates took a sledgehammer to Enphase's business by increasing the cost of capital and reducing the return on investment for Enphase customers. The cyclical nature of the solar industry isn't unique. Pretty much every trend depends on willing investors and capital to grow.
NASDAQ: ENPH
Key Data Points
The lesson here is that valuations matter, and the Nasdaq Composite and many growth stocks simply aren't as good a risk/potential reward balance as they were in the past. Once a quality growth stock falls, it can become a better value. And there's reason to believe a stock like Enphase is a better buy now that it has fallen and the long-term investment thesis remains intact. But the Nasdaq is coming off a 43.4% surge in 2023 alone. Earnings didn't come close to growing that much, leaving investor optimism rather than fundamentals to prop up valuations.
A more balanced bet
The S&P 500 and the Dow are a better value than the Nasdaq and will likely outperform the Nasdaq in 2024. The S&P 500 includes more tech than ever before. As discussed, the Dow is less oriented toward stodgy industrial stocks and includes many growth names across multiple sectors.
The difference is that the S&P 500 and the Dow also include a lot of value stocks. These slow-growing dividend payers may not have the glitz and glam of a high-flying AI stock. But what they do have are reliable earnings right now, not the prospect of reliable earnings in the future. The S&P 500 and the Dow are more of a bet on what is true today, rather than what could materialize several years from now.
Many of these dividend-paying companies also have recession resilience. Think Coca-Cola, Walmart, Procter & Gamble, utilities, and healthcare companies. These aren't the kind of companies with breakneck growth rates. But no matter what the economy is doing, folks must still care for basic needs.
How to approach 2024
Just because the Nasdaq is expensive doesn't mean you should avoid growth stocks entirely. Rather, the key takeaway is to be more selective with your investments.
If you're going to pay up for a stock, make sure to do so because you have high conviction in the long-term investment thesis.
If you're a risk-tolerant investor with a multi-decade time horizon, there's probably no need to change your strategy. But if you have a shorter time horizon or a balanced risk tolerance, it may be time to consider pockets of the market that are a better value.
