(Bloomberg) — Stock traders have been getting so rich for years betting that big companies will get even bigger that they’ve forgotten what a bubble looks like. They’re going to find out thanks to Nvidia Corp.
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So says Rob Arnott, known for his warnings about the dangers of inflated megacaps – and the designer of passive products for mitigating its supposed threat. With a 228% increase in 2023, Nvidia may be experiencing a revolution in computer science, but the stock is “a textbook example of a Big Market Delusion,” wrote the founder of Research Affiliates LLC.
“Overconfident markets paradoxically transform brilliant future business prospects into even more brilliant current stock prices,” Arnott wrote in a new research note, citing stocks trading at about 110 times earnings. “Nvidia is the modern day example of that genre: a great company with a price beyond perfection.”
Would Nvidia’s boom make the entire market collapse? “It’s very possible,” Arnott said in an interview.
Shares of Nvidia fell 1.1% on Tuesday.
Strong opinions about so-called bubbles are nothing new to Arnott, an architect of the so-called smart-beta system of rewiring traditional indexes in ways that limit the influence of giant corporations. He predicted in December 2020 that Tesla Inc. would be a drag on the S&P 500 after becoming the largest company ever added to the benchmark. The stock and the index are both up about 20% since he made that statement.
Valuation warnings rained down on the Nasdaq 100 long before Apple Inc. five years ago became the first US company with a trillion dollars. The index has returned nearly 15% annually since 2008. And virtually every attempt to beat the main exchange-traded fund tracking the index has failed.
Only one actively managed U.S. equity fund has managed to outperform the Nasdaq Invesco QQQ Trust Series 1 (ticker QQQ) over the past five, 10 and 15 years, according to a Bloomberg Intelligence analysis by David Cohne. This happened largely thanks to a heavy concentration in Tesla.
“You don’t want to get into a situation at this point where you’re betting against continued U.S. innovation and the impact it could have on the economy,” said Steve Chiavarone, senior portfolio manager and head of multi-asset solutions at Federated. Hermes. “These companies have more money than God. So there is resilience, there are balance sheets that are completely different from those of a few generations ago.”
Arnott says he is not opposed to capitalization-weighted indexing, where a company’s representation in an index is based on its market value. “If you just want to own the market, cap weighting is fine. But there are problems – and the most egregious problem is that anything that is too expensive today relative to future prospects is overweight in your portfolio,” he said.
After the peak of the technology bubble in March 2000, average stocks in the S&P 500 rose 25% over the next two years, while a capitalization-weighted index dominated by technology stocks fell 21%. Arnott points to the list of tech companies that were in the top 10 most valuable at the height of the dot-com bubble. No one was able to beat the market by the time the next bull run peaked in 2007, and only Microsoft Corp. and Oracle Corp. are leading the way today, twenty years later.
The tech giants that drove the Nasdaq 100 rally have been standouts for years because they took advantage of scalable business models that enabled them to generate strong profits and cash-rich balance sheets. They look “fantastic” when viewed over a period of time, including since 2014 when they really took off. “If you choose right now, you can’t beat the Q’s.”
But the positive sentiment towards Nvidia – which is the market leader in artificial intelligence processors – reflects too much confidence that its products will not be displaced by competitors, he says.
Many investors buy it on the assumption that its size—about $1.2 trillion—makes it a “safe game.” But it’s not “too big to fail,” it’s “too big to succeed,” according to Arnott.
“The risk that we’re wrong, that Nvidia is going to do incredible things and increase another 10-fold in the next decade, is possible,” he said. “I would say it’s not plausible, so I’d say it’s a bubble.”
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–With assistance from Subrat Patnaik, David Watkins, and Ryan Vlastelica.
(Updates to open up the market.)
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