- Nvidia's strong earnings report disappointed investors, highlighting how markets anticipate and move on expectations.
- High valuations can lead to lower future returns and make stocks vulnerable to even minor concerns.
- Understanding market behavior and valuation risks is crucial for long-term investment success.
- For less than $8 a month, InvestingPro's Fair Value tool helps you find which stocks to hold and which to dump at the click of a button.
Earlier this month, I outlined essential strategies for navigating market volatility, focusing on two key principles, which are worth revisiting now:
- Markets are forward-looking.
- Sentiment is driven by expectations.
Imagine tossing $1 into a well, magically returning $5. You try again the next day, and the well gives you $10.
This pattern continues for 10 days, and on the last day, you throw in $1 and receive $1,000. If you return on the 11th day, how much would you expect? Likely more than $1,000.
This positive reinforcement pattern mirrors the Nvidia (NASDAQ:NVDA) investors' experience.
The stock has rewarded investors consistently over the past years, often exceeding expectations. Yet, despite an outstanding quarterly report yesterday, the stock closed 2.10% lower and dropper further in after-hours trading, leaving many investors concerned.
What Caused the Tumble?
The quarterly report was strong, with earnings and revenues soaring over 100% year-on-year - a truly remarkable achievement. The guidance was equally promising.
But we must remember the two points I mentioned earlier.
First, markets anticipate.
But what do they anticipate? In Nvidia's case, the market reaction suggests concerns raised in the quarterly report, such as:
- Production issues with the new Blackwell Chip.
- The ROI of CAPEX, as investing in AI, though exciting, is costly (the other magnificent 7 can attest to that).
- Expected Q3 revenue, which, while impressive, fell slightly short of (astronomical) expectations.
And this brings us to valuations.
High valuations come with significant downsides. First, high valuations today mean lower expected future returns. Second, when valuations are high, the best possible outcomes are already priced in.
This leads us to point number two: markets move on expectations. When a stock trades at 70 times earnings and nearly 40 times sales, those valuations likely already factor in the best possible scenarios.
It takes very little to shake confidence and crack seemingly unbreakable beliefs.
I had the pleasure of speaking with Howard Marks a few months ago, and he illustrated this with an example about two piles: one contains an asset everyone wants, with sky-high valuations; the other contains an undervalued asset, dismissed by many.
Where is the opportunity? In the second pile, of course.
One last consideration: when a stock is worth more than $3 trillion, it’s tough to reach $5 or $10 trillion. Conversely, a stock worth $10 billion today might find it comparatively easier to reach $80 or $100 billion.
It’s always about numbers and behavioral finance.
I can’t predict what will happen to Nvidia today - whether it will close down double digits or rebound. But I do know this: if we want to thrive in the markets over the long haul, key investing principles, as discussed in earlier articles, should be our guideposts.
Everything else is just a roll of the dice.
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Disclaimer: This article is written for informational purposes only. It is not intended to encourage the purchase of assets in any way, nor does it constitute a solicitation, offer, recommendation or suggestion to invest. I would like to remind you that all assets are evaluated from multiple perspectives and are highly risky, so any investment decision and the associated risk is at the investor's own risk. We also do not provide any investment advisory services. We will never contact you to offer investment or advisory services.