The Network Effect and a NASDAQ Top

A few weeks ago I mentioned that I wouldn’t be surprised to see the NASDAQ index topping out around here. It then went on to make a new high.

That’s what happens when you pop your head up to make a call like that. You get it taken off. Despite being wrong, I’m not ready to give up on that call just yet.

Before I tell you why, understand that I’m not calling a crash or anything drastic. As I said before, you shouldn’t be surprised to see the NADAQ fall 15% or so from here.

That market has had a relentless run, without a decent correction in a long time. The reason behind that run is the increasing fervour that investors are showing towards tech stocks. It’s starting to sound a bit new-paradigm like.

I was at an investment conference last week and there was considerable discussion around Amazon, Alphabet (Google) Netflix and Facebook. Amazon was by far the most mentioned business.

These businesses all thrive on something called the ‘network effect’. That is, as more as more people use their product or service, it becomes more valuable.

This is why Amazon isn’t particularly interested in delivering bottom-line profits. They’re playing the long game. And the long game is to get more and more people into their network, which then increases the value of the overall company.

The network effect is most visible with a company like Facebook. As more and more people sign up and interact, the network of users becomes larger and Facebook becomes more valuable.

It all makes perfect sense.

But it is becoming a little too obvious? I mean, if it’s in the news it’s in the price, right? Is this network effect priced in, or does it have much longer to run?

This is where opinions diverge. The bulls would say this process has years to run. They would say that the disruption occurring because of the network effect is still in its early stages.

For example, one prediction made at the conference was that free-to-air TV would be the next to go. Apparently Amazon is spending more money on TV series than HBO. Free-to-air TV just will just not be able to compete.

Google and Facebook are stripping them of advertising revenue, while Amazon and Netflix are taking away viewers. It’s an assault from all angles.

The bears, on the other hand, see all this good news as being in the price. They view the lack of earnings or high valuations as reason to stay away from this sector.

Who’s right?

Both, probably. Opinions make a market. But right now the bulls are in charge. As I said, the rationale for investing in these ‘network’ stocks is simple and compelling. When something is simple and compelling, it becomes infectious. Everyone jumps on board.

And then there’s the general optimism surrounding the health of the tech sector in the US right now. Apple supplier, Taiwanese electronics company Foxconn, just announced a US$10 billion investment in a new LCD production facility in the US state of Wisconsin.

That’s not all, as the Financial Times reports:

Amazon promised to create 100,000 US jobs over the next two years and Intel said it would invest a total of $7bn in a new chipmaking plant in Arizona, while Indian IT group Infosys has pledged to hire 10,000 Americans in the next two years. 

In May, Apple announced a new $1bn “advanced manufacturing fund” aimed at boosting its US suppliers.

It’s all happening in tech land. But as I said, if it’s in the news, it’s in the price.

Putting it all together, an investment in the network stocks, or the chipmakers that will power the ongoing internet revolution, just seems a little too obvious right now.

That’s what it feels like, anyway. Which makes me concerned about a short term correction.

Following the investment conference I attended, one of the first things I did was bring up a chart of the NASDAQ. I wanted to see whether it looked strong or weak.

You can see the chart below.

There’s no doubt that it looks strong. I wouldn’t be betting against it, or shorting it, right now.

But I wouldn’t be a buyer here either.

There hasn’t been a decent correction since early 2016. That’s around 18 months without a change in sentiment. And, as I just explained, sentiment now seems overwhelmingly bullish.

Providing impetus to this view is the fact that the companies in question are all generating strong revenue and profit growth. And in the case of Amazon, the lack of profits is a part of the game plan. They’re building their network first. Profits will come later.

Source: Optuma
[Click to open new window]

In the chart I added the ‘relative strength index’ at the bottom. This is a momentum indicator. As you can see, the latest sharp run up to new highs came with a slight decline in momentum.

This tells you that, despite the new highs, momentum is starting to wane.

Of course, it doesn’t mean the NASDAQ is topping out. I might just be looking for any evidence I can find to support that view. But this development, combined with what feels like a little too much love for tech stocks, makes me cautious.

It certainly bears watching, anyway.

Just to be clear, I’m not saying tech stocks are about to collapse. But a 10–15% correction here would be healthy for the longer term structure of the market, and a buying opportunity if it came about.

I’m certainly not the only one with a cautious view, though. Last week, a very well-known hedge fund manager came out with a much more dire view of US markets in general.

More on that tomorrow…

Regards,
Greg


Greg Canavan is a Feature Editor at Money Morning and Head of Research at Port Phillip Publishing.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors.

And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really don’t know. No one does. The world is far too complex to understand.

When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases.

Greg puts this philosophy into action as the Editor of Crisis & Opportunity. As the name suggests, Greg sees opportunity in a crisis. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines traditional valuation techniques with charting analysis.

Read correctly, a chart contains all the information you need. It contains no opinions or emotion. Combine that with traditional stock analysis and you have a robust stock-selection strategy.

With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the basic, costly mistakes that most private investors do every time they buy a stock.

To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Money Morning here.

And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here.

Official websites and financial e-letters Greg writes for:


Money Morning Australia