NASDAQ to fall 70%?

The respected Gartner Group recently predicted that more than 90% of dot.coms would not make it. I would also add that it is likely that about 80% of all 'new economy high tech companies' will not make it.

This does not mean that all these companies will go bankrupt, but they may just languish and struggle to make money in years to come. As a result, I think that the NASDAQ 5000 level reached in mid March of this year marked the 'peak of inflated expectations,' an expression used by the Gartner Group to describe the recent speculative excesses.

This NASDAQ 5000 level may very well turn out to be as much of a 'milestone' in financial history as the Nikkei 39,000 level reached in December 1989. At the time, investors around the world firmly believed that 'this time was different' and that Japanese stocks had to be valued differently than all other stocks in the world.

When the NASDAQ reached in March the 5000 level, this Index consisted of about 4,800 stocks with a market capitalization in excess of US $6 trillion. Based on combined NASDAQ earnings estimates for the year 2000 of US$25bn, these stocks had, in March 2000, collectively a P/E of about 240!

Unprofitable issues were excluded from the P/E calculation, and I should like to stress that stocks like Cisco, Microsoft and Intel with their large market capitalization and 'relatively' modest valuations brought down the P/E of the NASDAQ.

Now, let us assumes that the NASDAQ with its $6 trillion valuation can grow its earnings at a compound rate of 20% per annum for the next ten years 'without interruption.' At the end of the period, in 2010, let us also assumes that the P/E of the NASDAQ will be twice its earnings growth rate (of 20% per annum).

In other words the NASDAQ will sell for 40 times earnings. Since the S&P 500 sells for about 28 times earnings, the assumption of a P/E of 40 for the NASDAQ is quite realistic. Under this scenario, the NASDAQ's current $25bn in earnings will grow to $155bn in ten years time and with a P/E of 40, these $155bn would have a value of $6.2 trillion.

In short, even under this extremely and, in my opinion, totally unrealistic scenario, the NASDAQ would at best be in ten years time where it was in March of this year.

Now let us assume that the NASDAQ earnings will not grow by 20% per annum but by 'only' 15% in each of the next ten years. Under this scenario, which I still regard as 'unrealistically optimistic,' NASDAQ earnings will grow to $100bn.

And again under the assumption of a P/E in ten years of twice the earnings growth rate (in this case a P/E of 30) the total market value of the NASDAQ would amount to US$3bn and an Index level of just 2,500 in 2010.

Now, I should like to emphasize the following: I am not familiar with any stock market index which, in the past, was able to grow its earnings for 10 years in a row by 15% or 20% per annum. Even to a non economist it should be clear that in the long run corporate profits cannot grow at a faster rate than nominal GDP (otherwise corporate profits would exceed GDP one day).

In fact, Professor Joseph Lakonishok of the University of Illinois has investigated whether corporate earnings can grow significantly faster than GDP. Lakonishok's research shows that in the US earnings in the 1950 - 1999 period had grown somewhat below nominal GDP.

Moreover, several studies have shown that selected group of stocks such as, today, the TMT sector are not likely to have strong and above average earnings growth for an extended period of time. According to these studies, in the past, only 3% of all companies in the S&P 500 have sustained growth of 20% for 10 years in a row and only one (Microsoft) has sustained growth of 20% for 15 years.

Thus, the NASDAQ with a recent market capitalization of US$6 trillion, which was about as large as all European or Asian stock markets combined, will most unlikely have earnings growth anywhere near 15%, let alone 20% per annum. In this respect we should not forget that the high tech sector is at present enjoying an unprecedented boom.

So, whereas US industrial production for all non-technology sectors (or 91% of total) has been flat over the last six months, technology output (9% of total US industrial production) is currently rising at an over 45% annual rate.

That this surge in high tech output is likely to lead to vast excess capacities and falling product prices ought to be clear, and is supported by recent earnings reports and future earning warnings by companies such as Nokia, Dell, Computer Associates and Agilent Technologies, Intel, etc, just to name a few. Even in the booming semiconductor industry 'all is not well,' because already next year additional capacity is likely to put pressure on prices, margins and profits.

Thus, I personally, would not be surprised if over the next 18 months the NASDAQ instead of showing rising earnings would actually have flat or even down earnings. Now, think what would happen to the valuation of high tech stocks if sometime over the next few years the present high tech boom is replaced by a high tech bust!

In my opinion, NASDAQ earnings, which might then amount to anywhere between $25 to 40bn would be valued with a P/E of maximum 30 to 40. Thus, the market capitalization of the NASDAQ would add up to somewhere between $750bn and $1.6 trillion, and this would correspond to a NASDAQ Index of between 800 and 1,800.

In other words, there is the possibility that the NASDAQ could fall from its March high of 5,000 by more than 70%. I know, some readers will say that I am nuts, but the Japanese Nikkei also fell by more than 70% from peak to through as well as most of the Asian markets after 1997. So why not the NASDAQ, which is valued far more dearly than these other markets ever were?

Lastly, consider this. At present, the value of a 10-year US Treasury bond would double in ten years time. In other words, in order for the NASDAQ to just match an almost riskless strategy (a ten-year treasury), the NASDAQ would have to double also! That would seem to be most unlikely considering the above analysis.

Recently, that is since March, the high tech sector and the NASDAQ have under-performed the S&P 500 and the Dow Jones Industrial. I expect this under-performance to continue and that the NASDAQ will visit the 2000 level long before it manages to make a new high. As in the case of the Nikkei, a new NASDAQ high may only occur after 10 or more years - if ever again.