Last week the the Nasdaq index reached an all time high. The previous high was set in March of 2000 during a period of euphoria among tech stocks. This was the last major stock index to reach an all time high.
The three common indexes, cited by news sources when reporting, on the stock market are the Dow Jones Industrial Average, the S&P 500, and the Nasdaq. The Dow Jones Industrial Average comprises of just 30 stocks, and is weighted by price. The S&P 500 has 500 stocks and is weighted by the market value of the companies. The Nasdaq comprises over 3,000 companies, and is also weighted by market value.
While the Nasdaq index is comprised of a large amount of companies, the largest firms, as is the case with the S&P 500, cause most of the price movement. The Nasdaq historically has been thought of, as comprising of younger, faster growing, and more speculative types of companies. While that is still true, the Nasdaq has the largest company by market capitalization, Apple Computer.
Nasdaq stocks typically perform better in up markets versus the Dow 30 and the S&P 500 and worse in down markets. This is not surprising given that many Nasdaq companies do not have a long-term history of earnings. Typically investors who are willing to accept a higher level of risk would invest in the Nasdaq.
The Nasdaq is commonly believed to be dominated by technology companies. Over time this dominance has lessened. When the Nasdaq reached it previous peak in 2000 Technology was 65 percent of the index. Today Technology represents 42 percent of the index, as Consumer Services and Health Care have also become major categories in the index.
With the Nasdaq reaching an all time high some investors are concerned that this might signal a market top. There are several important differences between the environment in 2,000 versus today.
When the Nasdaq had reached its all time high in 2000, it had been setting new highs for a number of years. With the Nasdaq just surpassing its all time high it certainly has the potential to set new highs for a period of time.
The most important difference between 2000 and now is that the earnings of Nasdaq companies are far greater than at the previous high. In 2000 some of the large tech companies were trading at close to 100 times earnings. Today the large tech companies in the Nasdaq are trading more in line with the overall market. There are, however, some Nasdaq companies, notably in social media trading at very high levels.
It should also be noted that over time prices of most items tend to rise. To the extent that corporate earnings are increasing stock prices should be setting new highs. This is not to imply that stock prices can’t be overvalued at times, but seeing a new high does not necessarily need to be a cause for concern.
One point for investors to consider is to be careful buying into a “hot” market, where prices seem to be greater than their underlying value. Prices may continue to rise for a period of time, but oftentimes when a correction occurs, it can take many years for your original investment to recover.
In the case of the Nasdaq it took 15 years, and over that time the dividend yield only averaged 1 percent per year. The safest investment, Treasury Bills, averaged a 2 percent annual return during those 15 years. The S&P 500, which was expensive in 2000, but not to the extent of the Nasdaq, has had a 5 percent annual total return over the past 15 years. That S&P 500 return is less than historical averages, but still considerably better than someone leaving their money in a savings account.
The Nasdaq has performed very well in recent years, as the stock market has recovered from its bottom in 2009. With the stock market at current levels I would expect returns for the Nasdaq and S&P 500 to be more modest versus recent years. For an aggressive investor having some money invested in Nasdaq stocks is appropriate, but certainly have investments in other areas, including foreign stocks.