Bubbles Hide In The Nasdaq 100

by: Fred Piard

I have recently explored possible links between stock prices and twenty-five fundamental data and ratios, sector by sector, for large caps and small caps, during the last 15 years. It gave me enough ideas for new strategies and maybe for another book. It has also allowed me to discover a weird phenomenon. It seems that investors are attracted by the worst Earnings-Per-Share change among the large caps of the Nasdaq.

Buying every 4 weeks the 8 stocks of the Nasdaq 100 with the lowest EPS change on the last 12 months would have returned 28.8% a year since 2005. It seems unbelievable.

Here is the equity curve of this "strategy" (in red), compared with the Nasdaq 100 index (in blue). It takes into account a 0.2% rate for transaction fees and slippage, which is realistic for very liquid stocks.

It shows an impressive risk-adjusted return for a so simple rule: the Sortino ratio is 1.07.

Here are the current holdings of the "portfolio":

Ticker Company Industry EPS Change TTM (%)
VRTX Vertex Pharmaceuticals Inc. Biotechnology -537,29
AMAT Applied Materials Inc. Semiconductors -143,9
SPLS Staples Inc. Specialty Retail -121,8
SIRI Sirius XM Radio Inc. Media -86,54
YHOO Yahoo Inc. Internet Software & Services -64,74
MCHP Microchip Technology Inc. Semiconductors -62,18
NUAN Nuance Communications Inc. Software -61,54
EXPE Expedia Inc. Internet & Catalog Retail -49,49

But wait a minute … Can we really speak of "strategy" and "portfolio"? Or should we call this a "bubble detector"?

In Quantitative Investing (Harriman House 2013), I characterize a scientific investing strategy with:

reasonable and measurable hypotheses about behaviors of the financial market so as to make investment decisions with an acceptable confidence in expected returns and risks.

This one looks far from reasonable. First, from a fundamental point of view. Second, because the same rule applied to a close universe on the same period gives a negative alpha. Here is the equity curve of buying every 4 weeks the 8% stocks of the S&P 500 with the lowest EPS change (rule in red, SPY in blue):

Moreover, here is what happened to the "8 worst EPS changes" rule applied to S&P 500 stocks of the Technology sector and Biotech industry between 1999 and 2005:

The total return is below -50% and the maximum drawdown (highest difference between peak and valley) is -94.5%.

It doesn't mean that it will happen exactly the same way again. But investors holding long positions in Nasdaq stocks with a falling EPS should take this as a warning. I don't recommend to short any of these stocks now. Technology stocks with a strong momentum are the first choice of fund managers needing to make their portfolios look better at the end of the year. The next window-dressing rally can drive such stocks significantly higher.

A bubble is characterized by a disconnection between the price and fundamentals. In my next article, you will see how the price has diverged from valuation and growth metrics for some of these stocks. Click on "Follow" if you don't want to miss it.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.