With the Nasdaq 100 index making new record highs on practically every day of 2017, and returning 32% during the past 12 months vs. "only" 19% for the S&P 500, Goldman's clients are starting to get concerned. And, as Goldman's David Kostin writes in his latest weekly letter, increasingly nervous investors are asking "whether NDX outperformance will continue."
Some facts: "100 of the largest stocks in the composite index, reached an all-time high [Friday] (5646), along with the S&P 500 (2399). Information Technology is the best performing sector YTD in both absolute and risk-adjusted terms and has led both indices. Technology accounts for 58% of NDX versus 23% of the S&P 500 and largely explains the 870 bp YTD outperformance (16% vs. 7%; see Exhibit 1)."
While Kostin provides some details about his outlook for the relative performance of the S&P and Nasdaq, what is most notable about the recent disconnect between the broader market and the tech heavy index, is just how concentrated the Nasdaq has become.
As Goldman shows in the chart below, the Nasdaq is so concentrated at the stock-level, the five largest stocks comprising 42% of the index compared with 13% of S&P 500.
Further demonstrating the skew, the top 25 stocks of the Nasdaq 100 account for 72% of the index weight.
Apple (AAPL) alone accounts for 12% of NDX versus 4% of the S&P 500. The index weight of AAPL and its stellar performance explains roughly 25% of the 79 pp excess return of NDX vs. S&P 500 since 2009 (229% vs. 150%). Alphabet (GOOGL), Microsoft (MSFT), Amazon (AMZN), and Facebook (FB) are the next four largest stocks in both indices (Exhibit 2). Each of the five stocks has beaten the S&P 500 YTD, by an average of 16 pp, and together have contributed 56% of NDX and 33% of S&P 500 returns YTD.
And yet despite what has been a clear outperformance for the Nasdaq, Goldman which has been increasingly bearish on the broader market, has a soft spot for the tech sector. This is how Kostin explains why the Nasdaq juggernaut may continue:
Current relative valuation may restrain upside, but superior sales and EPS growth prospects coupled with a larger weight in Technology suggests NDX total return of +2% vs. -1% for S&P 500 in the next 12 months. Excess return of 300 bp would rank in the 41st percentile since 2002."
The relative valuation of NDX vs. S&P 500 is in line with the 10-year average and will curb the magnitude of further outperformance. The valuation of NDX vs. S&P 500 using EV/Sales is most predictive of future relative returns. Current relative EV/Sales is 0.4 standard deviations below the 10-year average (Exhibit 3). A return to this average would suggest 3 pp of outperformance. In contrast, NDX vs. S&P 500 trades 0.8 standard deviations expensive on an EV/EBITDA basis and 0.1 standard deviations expensive using forward P/E. Taken together, the current relative valuation of NDX versus the S&P 500 appears consistent with the past 10 years.
The performance of NDX vs. S&P 500 is dependent on economic growth, but exhibits low sensitivity to other macro variables. NDX vs. S&P 500 returns show low correlation with changes in inflation, interest rates, USD, and oil. However, NDX is heavily concentrated in growth equities and NDX vs. S&P 500 relative returns are positively correlated with our growth factor (see Exhibit 4). Our US Economics team expects 2017 US GDP growth of 2.1%. Our US MAP score, a measure of economic data surprises, is in positive territory. Growth stocks typically outperform in this type of economic environment. Seven of the 25 largest NDX firms (GOOGL, AMZN, FB, ADBE, NFLX, PYPL, and CELG) meet our secular growth criteria (see Secular growth stocks for a secular stagnation economy, Jul 21, 2016). However, a reacceleration or collapse in economic growth would pose a risk to further NDX outperformance.
The micro landscape favors NDX versus S&P 500. Looking into 2018, consensus forecasts faster revenue and EPS growth for NDX versus S&P 500. Superior sales growth (8.4% vs. 5.3%) and earnings growth (13.5% vs. 9.7%) represent key drivers for further NDX outperformance. Since the start of the earnings season, revisions to consensus estimates have been more positive for NDX than for S&P 500. Long-term NDX earnings growth prospects are strong relative to S&P 500 (19% vs. 12%). However, while the 2018 estimates favor NDX, 2017 estimates are mixed. NDX sales in 2017 are forecast to grow by 8.3% vs. 7.5% for the overall S&P 500 (5.3% excluding Energy), the smallest gap since 2008. Similarly, NDX earnings are expected to rise by 9.0% in 2017, versus 10.7% for the S&P 500 (7.7% ex-Energy).
And, to be sure, Goldman's prop trading desk is more than eager to sell (or short) to any client one or more of the Top 5 companies that comprise nearly half the Nasdaq and whose market cap has never been higher.
Our GS research analysts have strong fundamental forecasts for the five largest stocks in NDX. Despite a slowdown in China, our Hardware team remains optimistic about AAPL’s upcoming product cycle and growth in services revenues. Our Software analysts forecast strong advertising revenue growth and exposure to the best secular trends in technology (mobile search, enterprise cloud computing) will drive 19% sales growth for GOOGL in 2018. The team is also upbeat on MSFT on the back of expense discipline and potential upside to out-year EPS. Our Internet analysts view FB as well-positioned in one of the best secular growth markets and expects 2018 consensus top-line estimates will climb from the current 28% towards their 30% forecast. The team believes consensus underestimates the revenue benefit to AMZN from the ongoing shifts to cloud computing and online retailing. They forecast 22% sales growth in 2018. The average return of the five stocks to their GS equity analyst price targets equals 19% versus 9% to the consensus targets.
What goes unsaid is that if central banks, like the SNB, can continue to create money out of thin air and continue bidding up names like AAPL, and the rest of the Nasdaq top 5, this trade is always effectively without downside.