Nvidia’s Rally Is Going to Show Traders What a Market Bubble Looks Like, Rob Arnott Says

Strong opinions about alleged bubbles are nothing new for Arnott, an architect of the so-called smart-beta system of rewiring traditional indexes in ways that limit the influence of giant companies. He predicted in December 2020 that Tesla Inc. would be a drag on the S&P 500 after it became the biggest company ever added to the benchmark. The stock and the index are both up about 20% since he made that case.

Warnings about valuations have rained down on the Nasdaq 100 since long before Apple Inc. became the first trillion-dollar US company five years ago. The index has returned nearly 15% annually since 2008. And virtually every effort to beat the main exchange-traded fund tracking the index has failed.

Only one actively managed stock mutual fund in the US has managed to outperform the Nasdaq Invesco QQQ Trust Series 1 (ticker QQQ) over the past five, 10 and 15 years, a Bloomberg Intelligence analysis by David Cohne found. It did so thanks largely to a heavy concentration in Tesla.

“You don’t want to be in a situation at this point where you’re betting against continued US innovation and the impacts that can have on the economy,” said Steve Chiavarone, senior portfolio manager and head of multi-asset solutions at Federated Hermes. “These companies, they’ve got more cash than God. So there’s a resiliency there, there’s balance sheets there that are altogether different than what you had a couple of generations ago.”

Source: Research Affiliates

Arnott says he’s not opposed to capitalization-weighted indexing, in which a company’s representation in an index is based on its market value. “If you just want to own the market, sure, cap-weighting is fine. But there are issues — and the most flagrant issue is that anything that is today overpriced relative to its future prospects is overweight in your portfolio,” he said.

Following the peak of the tech bubble in March 2000, the average stock in the S&P 500 rose by 25% over the next two years, while a cap-weighted index dominated by tech stocks fell by 21%. Arnott points to the list of tech firms that were the top 10 most-valuable at the peak of the dot-com bubble. None were able to beat the market by the time the next bull run peaked in 2007, and only Microsoft Corp. and Oracle Corp. are ahead today, two decades later.

The tech behemoths that have powered the Nasdaq 100 rally have been standouts for years as they became beneficiaries of scalable business models that allowed them to generate strong earnings and cash-heavy balance sheets. They look “fantastic” when viewed over specific time periods, including since 2014, when they really started to take off. “If you cherry pick right now, you can’t beat the Qs.”

But bullish sentiment toward Nvidia — which leads the market in artificial-intelligence processors — reflects too much certainty that its products won’t be displaced by competitors, he says.

Many investors are buying it with the assumption that its size — at roughly $1.2 trillion — makes it a “safe play.” 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’s off to incredible things and will go up another 10-fold in the coming 10 years is possible,” he said. “I would say it’s not plausible, and therefore I’m comfortable calling it a bubble.”

Tech Chart of the Day

Palantir Technologies Inc. fell 25% in August, its biggest monthly drop in a year, as analysts continued to turn bearish on the stock. Morgan Stanley downgraded its recommendation on the data-analysis software company’s shares, saying its valuation reflects “AI euphoria,” but that any tailwind from this trend will take time to materialize.

Top Tech Stories

• The early winners in artificial intelligence have strong fundamentals and less extreme valuations compared with stocks seen in previous periods of exuberance, according to Goldman Sachs Group Inc. strategists, rebutting concern that a bubble is building in AI.
• Elon Musk is blaming the Anti-Defamation League (ADL) for a slump in US advertising revenue on X Corp., the social media platform formerly known as Twitter.
• Electric vehicle giant Tesla Inc. says Australia should offer tax incentives to transform the mining nation into a hub for processing the minerals used to manufacture batteries.
• OpenAI Chief Executive Officer Sam Altman is the first person to get an Indonesian golden visa as Southeast Asia’s largest economy seeks to draw foreign investors.
• The low-profile yet surprising release of a new phone by Huawei Technologies Co. last week has sparked a hunt for potential beneficiaries, on the bet it represents a jump forward in China’s domestic chipmaking.

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