Melt-Ups and Melt-Downs

What Is a Melt-Up? (per Investopedia)

A melt-up is a sustained and often unexpected improvement in the investment performance of an asset or asset class, driven partly by a stampede of investors who don't want to miss out on its rise, rather than by fundamental improvements in the economy.

Let's consider a few data points and see whether we might be in a stock market melt-up.

The S&P 500 is up 22% in the last 3-1/2 months.

The S&P 500 has also closed higher in 14 of the last 15 weeks. That has not happened since 1972.

This has never occurred at any time when the stock market was also up +20% during the 15 weeks.

What is particularly interesting to me is that the stock market advances we have seen have been despite the increase in interest rates.

The usual pattern would be for stock prices to be under pressure as interest rates rise in that investors are drawn to higher yields and the relative safety of bonds, money market funds and interest-bearing bank deposits.

However, the S&P 500 is actually 15% higher than when the Fed started raising interest rates in March, 2022. Rates are now 525 basis points (5.25%) higher than they were two years ago.

Market analyst and investor John Hussman has calculated that the equity risk premium for stocks as compared to treasury yields right now is worse than it was in both 1929 and 1999.

We know what happened next in those two cases.

The DJIA from that high point in 1929.

Source: https://www.federalreservehistory.org/essays/stock-market-crash-of-1929

The tech-heavy NASDAQ from the dot.com high in 1999.

Source: https://vishalnoel7.medium.com/the-dot-com-bubble-of-2001-18bf817abcbd

It also should be noted that about 75% of the S&P 500 gains this year are due to the performance of just four stocks----Amazon, Meta, Microsoft and Nvidia.

You can see from this chart of the performance of these stocks compared to the overall S&P 500 how large the impact these names have had on the overall index.

 

Of course, no stock has had more influence on the S&P 500 than that of Nvidia.

It is up 231% over the last year, 77% over the last six months, 50% year-to-date and 32% in the last month.

Can you say melt-up?

Nvidia's stock price is being stoked based on its dominant position in the manufacture of chips that are being used in artificial intelligence applications.

I expressed reservations about Nvidia's stock price last May when its price/sales (not revenue, SALES) was 35. 

Since that time the stock price has doubled to almost $725 per share.

I guess that shows how much I know.

Nvidia has seen tremendous revenue growth over the last year but the stock price has increased even faster. The price sales/ ratio is now 40!

Source: Nvidia (NVDA) Price to Sales Ratio

Nvidia is now valued at over $1.7 trillion.

Let's put that in context.

That is now more than the entire Chinese stock market represented by shares on the Hong Kong stock exchange.

Source: https://www.marketwatch.com/story/nvidias-now-worth-as-much-as-the-entire-chinese-stock-market-8ca1208d

Nvidia's market cap is approaching the entire GDP of Canada of $1.9 trillion. Some market analysts believe Nvidia will surpass $2 trillion in value this year.

Nvidia has a higher market value than the entire S&P 500 Energy Sector although Nvidia right now is only producing $19 billion of total net income compared to the Energy Sector's $147 billion.

Nvidia's earnings from AI may ultimately justify that stratospheric stock price. However, that is extremely unlikely. Stocks like Amazon and Tesla once had similar price to sales ratios but there are many, many more companies that could not grow revenues and profits fast enough to meet the expectations of their stock price long term.

Nvidia's stock may go to even higher multiples of sales and earnings in the near term than where it is today. Crazy can get even crazier in the short term.

However, it is almost certain that a melt-down will follow the melt-up.

Whenever I see something like this unfold in the stock market I consider the words of former Sun Microsystems CEO Scott McNealy who provided this sage advice over 20 years ago when talking about the challenge of meeting the expectations of stock prices in the tech sector gone wild in the 2000 dot.com craze.

This interview came after many of those high flyers came back to earth, including his own company, which had a price/sales ratio of around 10 at the peak of the market.

At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?’— Scott McNealy, Business Week, 2002

It also reminds me of the story of the stock price of RCA (Radio Corporation of America) in the 1920's and 1930's.

RCA was the high-flying stock of the Roaring 1920's.  It was the leading company in the emerging "wireless" communication for the masses era".  The stock appreciated almost 10-fold between 1924 and 1929.  However, an investor who purchased RCA at its 1929 high had to wait 57 years to recoup their investment.  That is a long time. 

Investors got a little ahead of reality.

A more familiar name of recent years is Cisco Systems. It has been a great company for a long time.

However, 24 years after its high in the dot.com madness it still has not exceeded its value from a quarter century ago.

This is despite Cisco increasing revenues by over 400% and net income rising from $2 billion in 1999 to $12.6 billion in 2023.

It had a market cap of almost $400 billion in early 2000. Today, 24 years later. Cisco is valued at barely half of that ($204 billion). 

Some analysts state that there is an eerie resemblance between Cisco's stock price chart leading up to 1999-2000 and the stock performance of Nvidia recently.

Ho

Why did RCA and Cisco stock fall in price so rapidly?

They were both great companies that performed well for years and years despite the falling stock price.

The problem was that in both cases investors  became overly optimistic about a new, transformative technology.

However, at some point investors realized that the companies were not going to grow revenues and profits at 50%, 70% or 100% every year.

The same will prove true with AI.

At some point, sales or earnings growth is going to disappoint investors for the simple fact that castles cannot be built into the air to infinity.

A melt-down of the stock will follow.

It is no different with the broader stock market.

The S&P 500 is up 80% the last five years. The NASDAQ is +112%.

We will reach a point (probably sooner rather than later) when a realization will come to investors that the fundamentals of the economy are not as good as is being portrayed and that stocks are overvalued compared to interest rates.

A melt-down will follow.

Japan had a melt-up in stock prices in the late 1980's that peaked in 1990. 

It is only now after 34 years that the Nikkei index is almost back to where it was in 1990.

Source: https://tradingeconomics.com/japan/stock-market

Melt-ups are great.

However, melt-downs invariably follow.

Plan and protect yourself accordingly.