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Do you wonder why Nvidia's stock price keeps going up even though its price-to-earnings ratio is approaching 100 times, its price-to-sales ratio has surpassed 30 times, and its revenue growth has slowed down from 90% in Q2 2024 to 19% in Q4? It all started when the company unexpectedly doubled its revenue in one quarter due to demand for data centers that can handle artificial intelligence applications and the excitement around its hottest customer, OpenAI ChatGPT. There is no doubt that Nvidia is a great company. But it is certainly worth less than Amazon, with 10% of Amazon's revenue and half of its Free Cash Flow. What's going on? In today's post, I walk you through three structural changes in the stock market that fuel Nvidia's rally, irrespective of valuation and sanity. I'm Hoda Mehr, founder, and CEO of Stock Card, and on this blog and its accompanying YouTube channel and Podcast show, I share detailed fundamental analyses and interesting investment stories.
This post is part of our educational series to help you hone your fundamental investing skills. Catch up with past blog posts on How to Invest Like Buffett? How to Invest Like Charlie Munger, or how to Find the Highest-Returning Stocks? Remember, this content is for education and sharing ideas and not advice to buy or sell any securities. Sign up for a free account on Stock Card to get notified of these blog posts, YouTube videos, and Podcast shows every week. We only ask your name and email address when you sign up. Three Market Forces Pushing Nvidia's Stock UpThe stock market's structure has transformed due to three forces that power Nvidia's rally:
Passive Index InvestinOn the passive investing side, Nvidia is part of major indices, such as the S&P500 Index. All the funds that track the index must own the shares regardless of the valuation, keeping the demand high. However, the heightened demand continues beyond that. Benchmark's ComparisionThe second fuel behind Nvidia's rally is the benchmarking force. The more Nvidia's stock price goes up, the more significant the impact on the all-important S&P 500 Index and similar indices that are benchmarks for hundreds, if not thousands, of mutual funds and ETFs. Morningstar estimated that 85% of mutual funds that benchmarked themselves against the S&P 500 index or similar indices found themselves underperforming their benchmark last year because of Nvidia. Many will end up caving in under the market pressure and loading up on the stock to avoid underperformance, resulting in a higher Nvidia price, irrespective of the valuation. Algorithmic TradingAnd the last structural reason is the rise of machine-powered algorithmic trading. The more momentum the stock price shows, the more trading algorithms pour money into it, resulting in crazy valuation inflation. Can Nvidia Keep Going Uphat's why the stock price rally can continue regardless of valuation. But there is a caveat. If risk is the probability of permanent loss of capital, the higher the stock price, the higher the likelihood of decline. Suppose in one of the upcoming quarters Nvidia faces supply issues, as has happened in the past, competitors like AMD catch up, or an unforeseen macro factor impacts the chimp market. In that case, the market's structure will work against Nvidia. Algorithms will start selling Nvidia, and those who bought Nvidia reluctantly to stay in sync with their benchmark would have no reason to hold on to the stock. Regardless of the stock price direction and which stock we are discussing, one fact about the market's structure stays true: Index passive investing, benchmarking, and algorithmic trading are killing valuation analysis. One might even call it killing the market sanity. The stock market is structurally insane now. I'll see you next time!
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