Reversion to the Mean in Tech

Sentiment has shifted, seemingly overnight, in technology, as disparate unconnected actors are acting in concert. Many public tech companies are down significantly from all-time highs and venture funding in Q1 2022 slipped relative to Q4 2021. Many VCs are advising portfolio companies to cut burn.

The two most questions for tech startups, crypto traders, large tech companies, and investors are how much of a reversion occurs and what happens when liquidity goes to zero? This post addresses the first question.

Let’s examine the price memory levels on a widely-followed macroeconomic indicator and the potential implications for the NASDAQ.

Buffet’s Favorite Indicator

Warren’s Buffet’s supposed favorite indicator assesses how big the US stock market is to the actual economy. The indicator is calculated by comparing the capitalization of the US Wilshire 5000 index to US GDP.

The average has steadily risen through the decades, with a historical mean 0.9 ( source), implying a 1:1 relationship between the size of the US economy and the stock market. This ratio went well above this average in 2000, 2007, below post the Great Financial Crisis in 2008, and of course to all time record highs post in late 2021.

What now? Well GDP could fall, although in many US recessions (defined as two consecutive quarters of negative economic growth) the rate of GDP growth shrinks without full-year drops in GDP.

Stocks generally could fall out of favor, which appears to be happening now, perhaps driven by higher interest rates.

More important for the tech industry, tech stocks could fall more out of favor relative to stocks generally. The historical mean of the NASDAQ to total U.S. stock market cap is 20–25%, but has been in the 30–35% for many years as technology companies have become ascendant.

Perhaps you believe that stocks will revert toward their historical mean of 1x GDP but that tech remains a large part of our economy. In that scenario, the index can still fall to around 8,000, a 35% drop from current levels. If NASDAQ share of total market cap drops, then even lower levels are possible.

NASDAQ Index Level ($trillions) at various levels of NASDAQ Share of Total Stock Market Capitalization and Buffet Indicator

What are some key mean reversion points to watch for?

Implications for the Private Tech Market

What about valuations in private tech markets and startups?

If private tech markets follow public ones, valuations will come down a lot. Keep en eye on the trend in forward revenue multiples, as discussed by Tomasz Tunguz.

Also take a look at the BVP Nasdaq Emerging Cloud Index as a good proxy for private tech company valuation. Does this stabilize at COVID-19 2020 lows or something below.

Next Time: Liquidity

In markets such as these, liquidity is going to become a real factor in both public and private markets. When buyers disappear, prices don’t just fall, they can go to zero, as shown by the movement of Terra, a now infamous crypto coin.

More on this in the next post.

Any opinions or forecasts contained herein reflect the personal and subjective judgments and assumptions of the author only. There can be no assurance that developments will transpire as forecasted and actual results will be different. The accuracy of data is not guaranteed but represents the author’s best judgment and can be derived from a variety of sources. The information is subject to change at any time without notice.

Originally published at https://www.complexityeverywhere.com on May 12, 2022.

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lead @GCsports; write http://complexityeverywhere.com; trustee Village of Scarsdale, NY

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Sameer Ahuja

Sameer Ahuja

lead @GCsports; write http://complexityeverywhere.com; trustee Village of Scarsdale, NY

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