This year, investors have focused on the outlier returns of Nvidia Corporation (NVDA) and a handful of other large-cap stocks. Via a process of induction, they have assumed that the bull market has made a comeback. However, the data reveals that there is a bull market only in a small group of stocks that have benefitted from an artificial intelligence (“AI”) frenzy, and the broad market is struggling in a high-interest rate environment and a challenging geopolitical landscape.
Performance of NVDA, Magnificent 7, and Equal-Weight NASDAQ-100 and S&P 500 ETFs (Price Action Lab Blog – Norgate Data)
Since the start of last year, NVDA is up 440%, the equal-weighted magnificent 7 (GOOG, NVDA, MSFT, META, AMZN, TSLA, and MSFT) are up 155%, but the equal-weight NASDAQ-100 (QQEW) and S&P 500 (RSP) ETFs are up 38.3% and 16.7%, respectively.
The ARKK Innovation ETF (ARKK) is up 61.1% since 2023, but year-to-date it is down 7.6%.
Monthly Chart of ARKK ETF with Drawdown profile (Price Action Lab Blog – Norgate Data)
The ARKK ETF is down 65% from all-time monthly closing highs and has not even rebounded 23.6% from a maximum drawdown of 77%. This is one of the charts that better illustrates the actual current state of the tech market: fragility.
The AI frenzy is supporting broader cap-weighted indexes with promises of significant innovations and an acceleration toward a better world. The reality could be different, or even quite the opposite. Although AI is positive for a handful of corporations and bullish for the economy in the short term, the long-term impact is not well understood. One of the reasons for that is that AI increases complexity, and making forecasts is impossible. A massive application of AI could be beneficial and economically rewarding or could cause a deflationary spiral due to massive layoffs and an accelerated conversion of labor to capital. The current frenzy is helping support the market during an election year.
Nvidia is an outlier
I looked at all stocks in the Russell 1000 index and calculated the total return since the bottom of the market on October 12., 2022, or a period of 343 trading days. Below are the results for the top 20 stocks.
Top 20 stocks on Russell 1000 in last 343 trading days (Price Action Lab Blog – Norgate Data)
As it turned out, NVDA is an outlier, with a 580.8% gain in the period considered. In addition, 637 stocks in this index have underperformed the S&P 500 Index (SP500) in the same period. A massive outlier with two trillion dollars in capitalization is driving the whole market up, with the help of a few other large capitalization stocks like Microsoft (MSFT). Microsoft has invested in the software, and Nvidia is making the hardware for the new AI applications.
The tech market is fragile
Despite the AI frenzy, the tech market has been in mean-reversion since the dot-com top, and it is fragile. Usually, investors and traders look at the charts, and if prices are trending up, they declare a market bullish. However, quants look at returns because it is the return on invested capital that matters.
Monthly chart of NASDAQ-100 Index with rolling 144-month returns (Price Action Lab Blog – Norgate Data)
If we look at the 144-month (12-year) rolling return of the NASDAQ 100-Index (NDX), we notice a few disturbing facts:
- In March 2000, the 144-month return peaked above four standard deviations of the available sample and reached a high of 2,438%.
- A collapse of the 144-month return followed, with a bottom in December 2011 at -14%.
In other words, after the dot-com top, a vicious mean-reversion dynamic went into effect. This dynamic is still in place due to underlying economic, political, and geopolitical factors. The U.S. tech market is still undergoing a mean reversion from the irrational exuberance of the 1990s. The AI frenzy is currently an attempt to enforce a new uptrend and escape from the mean reversion trap. We are going to see similar gains as in the 1990s. It is going to be a volatile ride, with the frequency of boom and bust cycles probably increasing.
Summary
Outlier gains in a few large-cap stocks driven by an AI frenzy have supported broader large-cap market indexes this year, but the market is fragile. The tech market’s performance peaked in 2000, and since then, it has been struggling. Despite trillions of dollars in quantitative easing and stimulus programs, reasonable investing horizon returns are nothing like the returns realized in the 1990s. The broader tech market is struggling, and the focus is on AI developments that promise an acceleration toward a new economic model.
Due to the inherent complexity of this new tech world, it is impossible to make forecasts: this new economic model could be a better one or lead to a deflationary spiral. However, in the short term, there are benefits from a handful of corporations and the support of the market during an election year.
After all boom cycles, a bust follows, and with high probability, this time will not be any different. Traders are trying to take advantage of the AI frenzy, but investors, due to their slower response, need to evaluate their exposure to sectors that could be most affected by a bust and include diversifiers to protect their assets in the event of another bear market.
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