This year has been tough for investors, particularly those who flock toward growth stocks. Just about every major industry has been impacted in some form or fashion by President Donald Trump's new tariff policies.
While the broader implications of these import taxes are still unfolding, one sector that has faced abnormally large headwinds is technology. For the first time in nearly three years, investing in the artificial intelligence (AI) market hasn't necessarily resulted in outsized gains.
Nevertheless, one pocket of the AI realm that has managed to circumvent the panic-selling this year is quantum computing. As of this writing (July 17), the Defiance Quantum ETF has gained 17% so far this year -- roughly double the returns seen in the S&P 500 and Nasdaq Composite.
With quantum computing stocks trouncing the broader market, now may be an appropriate time to assess valuations in the sector and compare them to prior periods of heightened enthusiasm.
Image source: Getty Images.
What is a stock market bubble, and what are some examples?
One of the most basic mistakes investors make is assessing a company's valuation based on its stock price. In other words, if the stock price is low, an investor might mistakenly view the company as "cheap" (and vice versa).
Smart investors understand that there are far more parameters than the share price that help determine a company's valuation. Underlying financial metrics, such as revenue, gross margins, profitability, free cash flow, cash, and debt, should all play a factor in assessing the health of a business.
From there, more sophisticated analysis requires investors to benchmark these figures and their growth rates against a set of peers to get a better sense of how the business in question compares to the broader competitive landscape.
Many investors do not take the time to perform the due diligence exercise above and instead choose to follow broader momentum. Unfortunately, this can lead to abnormally inflated stock prices -- those that are incongruent with the underlying fundamentals of the business.
Generally speaking, reality begins to set in and these companies are unable to sustain their overstretched valuations, eventually leading to harsh, dramatic sell-offs. This phenomenon is known as a stock market bubble.
In the charts below, I've illustrated some valuation trends across two notable stock market bubbles.
AMZN PS Ratio data by YCharts. PS Ratio = price-to-sales ratio.
The chart above illustrates the price-to-sales (P/S) ratios for a number of high-flying internet stocks during the dot-com bubble of the late 1990s. As the trends above make clear, each of the companies in the peer set above trades at much more normalized valuation multiples today when compared to their peaks during the internet boom.
ZM PS Ratio data by YCharts. PS Ratio = price-to-sales ratio.
Investors witnessed a similar theme in overstretched valuations during the peak days of the COVID-19 pandemic. Companies such as Zoom Communications, Wayfair, and Peloton witnessed abnormal demand for their respective product offerings as remote work became the norm.
As the trends seen above demonstrate, however, these growth tailwinds were not permanent. Today, none of these COVID stocks are seen as compelling growth opportunities, and their cratering valuations are a sobering reminder of the aftermath of bubbles bursting.
How do quantum computing stocks compare to the valuations above?
Over the last year, IonQ (IONQ 6.31%), Rigetti Computing (RGTI 6.54%), D-Wave Quantum (QBTS 6.93%), and Quantum Computing (QUBT 6.97%) have emerged as popular names fueling the quantum computing movement.
IONQ PS Ratio data by YCharts. PS Ratio = price-to-sales ratio.
With a P/S multiple of over 5,700, the tiny Quantum Computing business is the clear outlier in the quantum computing cohort illustrated above. Even so, Rigetti, IonQ, and D-Wave each boast P/S ratios that are either considerably higher or in line with the darlings of the dot-com and COVID bubbles.
Are we in a quantum computing stock bubble?
The quantum computing stocks referenced above are highly speculative -- arguably even more so than the highfliers during the internet era. Unlike then, today's technology behemoths, such as Amazon, Microsoft, eBay, and Cisco, have evolved into sophisticated platform businesses with diversified ecosystems.
This provides them with the scale and financial flexibility to explore emerging fields such as quantum computing. Smaller players, such as IonQ, Rigetti, D-Wave, and Quantum Computing, currently face intense competition from big tech -- something the dot-com businesses did not.
NYSE: IONQ
Key Data Points
Given the valuation analyses explored above, many popular quantum computing stocks are clearly trading at abnormally high and historically unsustainable valuation levels. For these reasons, I think companies such as IonQ, Rigetti, D-Wave, and Quantum Computing have entered bubble territory.
With that said, many big tech companies in the "Magnificent Seven" are exploring quantum applications as well. Many of these companies trade for much more reasonable valuations. While I am not convinced the broader quantum computing opportunity is necessarily in a bubble, I believe investors need to be cautious and thoughtful when selecting which quantum computing stocks to invest in.
And the best choices will rarely be high-flying specialists with big dreams and small revenue streams.
