When does the market top? Looking back at prior bubbles, one rule of thumb to internalize is “when price goes vertical, a top may be near”. If you’re the mathematical type, think of the angle of ascent that price takes. Usually, a bull market plods along, slow price rises push up against the Wall of Worry. From day to day nothing seems too dramatic but when you look back over a full year of price action, the percentage returns are impressive.
And then there’s a whole other kind of bullish action. The one where the angle of ascent is so steep that the price rises like a rocket ship and those who missed the gains are infused with fear of missing out, and get tempted to buy… the top.
Key Points
- One sign of a market top is when prices go vertical, meaning they rise very quickly. Another sign of a market top is when the number of new 52-week highs declines. A market top can also be signaled by a decline in the rate of advance of the NYSE.
- Nvidia’s meteoric rise has been fueled by the company’s strong growth prospects in the AI market. However, the stock is now trading at a very high valuation, with a price-to-sales ratio of over 25. This suggests that the stock may be overvalued.
- Stocks can remain overvalued for extended time periods but that doesn’t mean chasing it makes sense, and indeed it can lead to untold losses.
1 Bubbly AI Stock
One stock that has all the hallmarks of bubble behavior now is Nvidia. On May 25, it rose 24% overnight to climb to $380 per share. Vertical price action indeed.
That translated to a rise of over $200 billion to nearly a trillion dollar market capitalization… for a stock that generated $26 billion in sales last year and is forecast to do $40 billion this year. To put some perspective on this if you created a business generating $1 million per year, that price-to-sales multiple would translate to a $25 million valuation.
Nvidia doesn’t just have a sky high price-to-sales multiple but also a jaw-dropping price-to-earnings ratio of 196x. To put that in perspective, imagine your million dollar a business had $100,000 in profits annually. If it had the same P/E as Nvidia it would be valued at $20,000,000. In the real world that doesn’t happen unless you’ve got a narrative so compelling that investors can’t help but scoop up the business. In the case of Nvidia that narrative is AI.
When ChatGPT launched by OpenAI, the world got savvy to the potential of AI for the first time. The average person could envisage how disruptive AI could be from marketing to legal professions, from finance to administrative work, and far beyond. And the company powering the revolution with its chips: Nvidia.
So should you buy into the AI narrative now?
Narrative Vs Price
History taught investors in 2021-22 that narrative is a dangerous leader to follow. The narrative around Affirm was that it would disrupt credit cards. Why get a credit card and pay up to 29.99% in interest charges when you could pay installments at much lower costs using Affirm? Upstart could evaluate credit scores better than FICO, or so the story was spun. Both fell from sky high valuations driven by narratives to plummet as much as 90% and more.
An investor who is charmed by narrative can quickly be punished by the market because a virtual spell is cast on the investor who ignores the technical sell signals and fundamental overvaluation. The price on the way up is so feverish and every dip bought so that when the price finally corrects a disbelief and more precisely a denial sweeps over the investor that price will recover.
The lesson should be clear when prices go vertical don’t chase the final throes because the temptation to buy and stick with an overvalued stock for the sake of narrative is more powerful than most imagine… and can create losses larger than can be fathomed.