Summary: Based on the data and analysis presented below, the tech-heavy Nasdaq is no longer operating according to fundamentals. Returns, profit and greed now run the show.
Much has been made about the Nasdaq’s outperformance relative to other U.S. indices this year. The primarily technology-based index is up over 20% year to date through July 14, 2020 while many other companies struggle to reach their former highs likely seen in February. This large thrust of momentum to the upside in the index shows a stark contrast between now and around 4 months ago when the Nasdaq was down near 40% for the year. This turbulence has caused the index to skyrocket far above its 200-day moving average; a metric many traders and investors consider a staple of gauging longer-term sentiment. Given the magnitude of these gains in the Nasdaq what can we expect from the index going forward?
To answer this question, I first calculated the one-year rolling z-score of the difference between the Nasdaq’s daily closing price and the daily 200-day simple moving average. I then split up these z-scores into 6 different groups as shown by the first table below. After packaging my data into nice definable groupings I was then able to analyze their results to show the average 2-week, 1-month, 3-month, 6-month and 1-year forward returns resulting from the Nasdaq given its z-score placing relative to its 200-day simple moving average.
The table above shows these various average forward returns given the groupings depicted in the earlier table. The occurrences of these groupings represent a positively skewed leptokurtic distribution that one would expect to find when analyzing nearly any major U.S. index over long periods of time. The data does become interesting when you look at the groupings with the highest forward returns over the different time frames. The most positive group in the 2-week and 1-month time frames is where the Nasdaq is pushing far above what would be considered normal from its 200 day. Conversely, over the 3-month, 6-month, and 1-year time frames the most positive group is the first one, where the Nasdaq is considerably lower than its 200-day given a one-year historical context.
The easiest way to summarize these differences is to imagine that the 2-week and 1-month averages tend to be driven by momentum while the longer time frames are seemingly more driven by long-term valuations and mean reversion ideologies. This is not to say that the longer time frames don’t experience momentum. The 6th group is still the second most positive category when analyzing these lengths of time. They simply don’t matter as much in the long run.
To better visualize what types of returns we can expect from the Nasdaq, as well as each of our self-created z-score groups, I have created this scatter plot shown above. This chart takes each of our data points split into their respective groups and plots it against their 1-year forward returns. The linear black line in each group’s column shows the current trend in accordance with its least squares residual. The x axis for each group’s column is also different to get a better understanding of the clustering of data.
As you can see based on the trend lines in groups 1 and 6, they have an inverse relationship. When the Nasdaq is already far extended above the 200 day, it has historically continued to further extend itself and, in return, gives way to some of the largest 1-year forward returns we see in this study.
Consequently, when we are already at a -2 standard deviation beneath the 200 day, going any lower means that we are more and more likely to have a more violent reversion to the mean. In other words, when things are bad, things seem to either get better slowly or get worse before getting much better in a hurry (sound familiar?..cough cough.. March of 2020).
While the powers that be in the investment industry mandate that I must tell you that history is no guarantee of future returns, I ask you this: Do we have a better metric of which to go by? Sure, nothing in life is guaranteed other than Ghislaine Maxwell’s impending suicide, but written history provides us with the data we use to propel our society forward. What this data tells me is that we are now entering a phase of the Nasdaq where fundamentals are out the window. Returns, profit and greed now run the show and if you stand in the way of these things you may just be the next up to be canceled.
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Copyright © 2020 Ryan Preiss