A 2023 stock-market rally led by megacap tech names is stirring fears another bubble may be forming as the Nasdaq Composite index significantly outpaces strong gains for the S&P 500.
But a longer term look at the tape indicates the Nasdaq may merely be playing catch-up with the large-cap U.S. benchmark, argued Jessica Rabe, co-founder of DataTrek Research, in a Thursday note, who also warned against losing sight of how dismal 2022 was for stocks.
The Nasdaq
COMP,
was up 37.2% year-to-date through Wednesday’s close, far outpacing the S&P 500’s
SPX,
18.9% rally, but over the last three years, the S&P 500, up 42%, has outpaced the Nasdaq’s 37% rise, Rabe observed.
DataTrek ran the three-year rolling returns for both the S&P 500 and the Nasdaq Composite over the last 50 years to put 2022’s losses and 2023’s rebounds into a larger context. Rabe said they chose those time frames because the three-year period helps smooth out year-to-year seasonality and volatility, and five decades capture a variety of business, interest rate and valuation cycles (see chart below).
The Nasdaq Composite tends to outperform the S&P 500 over a 3-year time horizon but it is also more volatile, as would be expected, Rabe noted. The three-year average price return for the Nasdaq was 41.% versus 29% for the S&P 500 back to 1974.
The Nasdaq Composite is up 37.1% over the last three years, versus 42% for the S&P 500, making this year’s performance look like a reversion to the longer term mean.
“The Nasdaq has underperformed the S&P by almost 500 basis points over the last three years, when the Comp typically outperforms by a much larger margin (+1,220 bps). It therefore makes sense that the Nasdaq is playing some catch-up in 2023,” the analyst said.
The data also show 3-year returns rarely go negative and that they continue to trade in similar bands to prior cycles. “Barring a geopolitical or economic shock, both the Nasdaq and S&P tend to generate positive, double-digit returns over three-year periods,” she said.
Even with the Nasdaq and S&P’s double-digit rallies this year, three-year returns for both indexes are relatively ordinary as compared with historical norms, Rabe noted. The Composite’s 37.1% return over the last three years is slightly below the average of 41.2% but well within one standard deviation to the downside. The S&P 500’s 42% rise over the same stretch tops its average of 29% but is well within standard deviation to the upside, she said.
What does it all mean? Rabe acknowledged that stock valuations are rich and that companies need to keep delivering on earnings, but said it’s also worth noting that part of the impressive rallies for both indexes can be explained in part as a reversion to historical averages. She noted that the S&P 500 and Nasdaq’s 2022 performances were nearly or just as bad as those seen in the 1973-74 oil crisis and recession, the period around the bursting of the dot-com bubble, the lead-up to the second Gulf War, and the 2007-09 financial crisis.
“This year’s gains so far have gotten them back closer to their 3-year average returns but are nowhere near bubble territory,” she said.
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