Global Troubles Spell Nasdaq Losses

Equity benchmarks across the globe have felt the China reverberation as commodity deflation suddenly turns to commodity crisis. For stocks, this has been a reality check with many benchmarks trending nearer to the August lows with each passing session. After the spectacular rout that ensued before China got a grip on its own fledging capital markets, it is unsurprising that the same questions about the global economy are coming back to the forefront as risk aversion begins to grip markets and investors seek out safe havens. The most recent bout of tumult has seen equity valuations sink with the Nasdaq Composite showing an emerging bearish bias thanks in large part to the appearance of the death cross technical formation. With crisis conditions back on the horizon and the situation in China unlikely to abate soon, losses in equity markets might still be in their infancy.

The Fundamental Picture

The Nasdaq Composite is largely a technology weighted index with over 5000 companies as constituents of the index. The Composite is weighted based on the market capitalization of the component companies, the single largest component being Apple which accounts for well over 10% of the index. At present levels, the index is very sensitive to the world’s most valuable company, with movements in Apple translating often to momentum in the index. Other famous components include Microsoft, which represents the second largest company by market capitalization in the Composite. Technology valuations in particular have come under fire over the course of the last year with Federal Reserve Chairwoman Janet Yellen complaining about the “stretched valuations.” The latest retreat in the index highlights the growing chorus of bearish calls from equity analysts and revisions lower in the earnings outlook.

In general, the Nasdaq Composite has a multiples valuation that is only eclipsed by the Russell 2000 which has more components when compared to the more narrow Dow Jones and S&P 500 indices. Currently, the trailing twelve month price-to-earnings ratio for the Nasdaq Composite is 25.53. To put this in a historical perspective, the average price-to-earnings ratio for the S&P 500 since the index was founded is 15.55, below the current 18.90 multiple. With this in mind, the Nasdaq Composite might see its very own over-extended multiple retreat after climbing above 28 back in May. The correction in the valuation however is likely just beginning as the index faces a host of challenges to the outlook. While 1-year performance for the index is modestly positive at 0.17%, year-to-date the index has lost -4.70% with the Nasdaq Composite giving up -8.97% in the last three months alone.  If the valuation multiple were to revert to more historical levels, current price action might only signal the beginning of a weak outlook for the Nasdaq Composite.