There is a High Risk of a Crash in This Market Sector. NVIDIA Investors, Pay Attention

The recent correction in the U.S. stock market has helped deflate what many believed to be an unsustainable bubble. However, despite the pullback, some high-profile stocks, including Nvidia (NVDA) and Broadcom (AVGO), still face a significant risk of a sharp decline.

‍

This assessment is based on an algorithm designed to identify market bubbles at risk of bursting, developed by Robin Greenwood and Andrei Shleifer of Harvard University, along with Yang You of the University of Hong Kong.

‍

How the Bubble Prediction Model Works

While the researchers' methodology has some complex elements, its core concept is straightforward: the more an asset soars, the greater the likelihood of a crash. The professors define a “crash” as a decline of at least 40% over a two-year period and estimate the probability of such an event by studying market trends dating back to the 1920s.

‍

Their findings indicate that an industry is at high risk of a downturn when it experiences extraordinary gains relative to the broader market:

• If an industry has outperformed the market by 100 percentage points over the past two years, it has a 53% probability of crashing.
• If the industry’s outperformance reaches 125 percentage points, the crash probability jumps to 76%.
• If its two-year return is 150 percentage points above the market, the likelihood of a crash surges to 80%.

‍

Tracking Market Signals

Six months ago, a report based on the professors’ research highlighted 14 stocks that met their bubble criteria—meaning they belonged to industries that had exceeded the market’s performance by more than 100 percentage points in the prior two years. These stocks, on average, have since underperformed the S&P 500 by 23 percentage points, lending credibility to the algorithm’s predictions.

‍

Currently, the only industry that meets the bubble criteria is the S&P 1500 Semiconductors and Semiconductor Equipment sector (SP1500.4530). Over the past two years, this industry has posted an unannualized return of 165.5%, which is 117.7 percentage points higher than the S&P 500’s return over the same period.

‍

According to the professors' model, this level of outperformance suggests a crash probability exceeding 70%.

‍

The Most Vulnerable Stocks

Since the semiconductor index is market-cap weighted, its largest components are the most closely tied to its overall performance and therefore face the greatest risk. The five biggest stocks in the S&P 1500 Semiconductors and Semiconductor Equipment Index, which collectively account for 89% of the sector’s total market cap, are:

• Nvidia (NVDA) – Makes up 60% of the index
• Broadcom (AVGO)
• Qualcomm (QCOM)
• Advanced Micro Devices (AMD)
• Texas Instruments (TXN)

‍

Given their dominance in the semiconductor sector, these companies are particularly susceptible to a downturn if the industry experiences a correction.

‍

Is the Overall Stock Market in a Bubble?

Interestingly, while some parts of the market show signs of excess, the research does not indicate that the entire U.S. stock market is at heightened risk of a major crash.

‍

The S&P 500’s unannualized two-year return currently stands at 47.7%, which is strong but not extreme enough to suggest an unsustainable bubble.

‍

Additionally, State Street, a global investment firm based in Boston, has developed "froth forecasts" based on the professors’ bubble research. Their latest analysis indicates that the U.S. stock market has only a 17% chance of experiencing a crash over the next two years—a probability lower than the average crash risk projected over the past five years.

‍

Key Takeaways

While concerns of a broad market collapse seem overblown, certain high-flying stocks—especially in the semiconductor sector—may be at risk. The rapid gains in Nvidia, Broadcom, and other semiconductor giants over the past two years increase their likelihood of experiencing a sharp decline, based on historical trends.

‍

However, for the market as a whole, current valuation levels do not strongly suggest a bubble, and the overall risk of a crash remains moderate.

‍