http://awealthofcommonsense.com/2017/06/putting-the-tech-wreck-into-perspective/

Stock markets are doing well this year, but there’s one index that is clearly head and shoulders above the rest: the Nasdaq. But of course, trading on the Nasdaq is not without its risks.

Whereas the broader European and US markets have risen around 7 to 8%, a Nasdaq investment has gained twice as much (15%) during the first six months of the year. And if you think that’s just dumb luck, think again: the average annual price performance was 16.4% in the last five years, which means your annual return would have been nearly 4% higher if you had invested in this technology market rather than in the broader S&P 500.

How much longer can this good fortune continue? More and more people have been asking themselves this same question recently, particularly since the so-called FAANG (Facebook, Amazon, Apple, Netflix and Google) stocks − and in their wake the broader Nasdaq index – have suddenly started to experience heavy selling pressure in recent weeks. Of course you still read enough reassuring news that the Nasdaq Composite is nowhere near as expensive in valuation terms as it was at the time of the dotcom bubble, but still: as a whole, it is currently trading at 32 times reported earnings, which seems a bit high compared to the figures for the S&P 500 or the AEX (21x and 20x, respectively).

All or nothing
The Nasdaq is known for its tendency to go to extremes. When the markets are strong, the Nasdaq does better, but when they’re weak, brace yourself. That’s very clearly illustrated by this week’s graph. What it shows is the maximum loss if you were unlucky enough to consistently buy at the top of the market. I’ve included a second graph to illustrate that concept more clearly.

Investing on the Nasdaq is quite a risky business…

source: Robeco & Bloomberg

This graph shows the Nasdaq (blue line) versus its highest level to date (in orange). So when it hits a new high, the orange line rises too. And when it slips, the orange line levels off. The blue area in the first graph represents the percentage difference between the orange and blue lines in the second graph. Because the first graph shows the maximum loss, it is also referred to as the maximum drawdown graph.

And as clearly shown, the Nasdaq’s losses (shown in blue) have almost always been greater than the S&P 500’s (in orange), which indeed confirms that investing on the Nasdaq is not without risk. So while the first graph is a good warning, it actually only tells half the story: it shows the risks, but not the rewards.

The bright side
But is there also a ‘maximum profit’ graph? While it sounds plausible enough, the reality is a bit more complicated. Whereas the highs closely follow market trends (every now and then there’s a new high), the lows prove fairly stable: the low recorded in December 1975 has remained the lowest point for the last 40 years, and it doesn’t look like that’s going to change anytime soon. So a maximum profit graph using data from 1975 onwards would be a lot like the movement of the Nasdaq itself: not particularly enlightening.

After some calculating and puzzling, I came up with an alternative. Whereas the maximum loss is calculated in relation to the market’s peak, the maximum profit would obviously be determined in relation to the trough. The method I chose to make the lows follow the market was to take the lowest level of the last two years. The lows then look like this.

….but you can also reverse it

source: Robeco & Bloomberg

I have to admit the choice was arbitrary: I could just as easily have taken the averages. The term maximum profit doesn’t really apply, either: it’s the maximum profit over a period of two years. Still, it’s interesting to see whether the Nasdaq is still just as volatile on the upside, too. Not surprisingly, the answer is yes, it is. To avoid the distraction of the dotcom bubble, which is definitely an outlier, I decided to cut off the axis at 150%.

All or nothing

source: Robeco & Bloomberg

The nice thing about this last graph is it shows that over the last seven years, the Nasdaq’s highs haven’t actually been that high. While the blue line remains pretty consistently above the orange line, the difference between the two values seems negligible compared to that seen in the ‘70s, ‘80s and ‘90s. Apparently, there wasn’t so much madness during this cycle, after all.

All or nothing: so did that ultimately translate into higher returns? It looks that way: if you had invested USD 100 on the Nasdaq in early 1971, it would now be worth USD 6150 (an annual return of 9.3%). If you had invested the same USD 100 on the S&P 500, it would now ‘only’ be worth USD 2510 (an annual return of 7.2%). The problem, however, is that these results don’t take dividends into account: they only look at the price movements of the broad indices. Unfortunately, I don’t have dividend data going back to 1971 for both indices, but it seems unlikely that the S&P 500’s dividends would have consistently been 2.1% higher than the Nasdaq’s. Since 2002, they have only been 1.1% higher. In other words, the Nasdaq probably has had better returns.

The question however is, were they high enough to compensate for all the sleepless nights?