Why NVIDIA is in Danger of Crashing Along With These Other 13 High-Flying Stocks

The home-building and semiconductor industries appear to be exhibiting signs of a valuation bubble. This conclusion arises from applying the methodology of a notable academic study conducted five years ago to the current stock market environment. The study, titled "Bubbles for Fama," was authored by Robin Greenwood and Andrei Schleifer of Harvard University, along with Yang You from the University of Hong Kong. In this research, the professors defined bubbles and their subsequent deflation within specific industries, rather than across the entire market.

‍

According to the study, when a particular industry outperforms the broader market by at least 100 percentage points over a two-year period, there is a 53% probability that it will experience a decline of at least 40% over the following two years. This risk increases as the outperformance, or alpha, grows. If an industry’s two-year alpha reaches 125 percentage points, the probability of a 40% drop rises to 76%. When the alpha expands to 150 percentage points, the likelihood of such a decline climbs even further to 80%.

‍

These probabilities offer a sobering perspective when applied to the current performance of the semiconductor and home-building industries. The Semiconductors & Semiconductor Equipment Industry Group Index has surged 176 percentage points ahead of the broad market over the past two years, according to data from FactSet. Meanwhile, the S&P 1500 Homebuilding Sub-Industry Index has delivered an alpha of 121 percentage points over the same period.

‍

However, it’s essential to remember that these findings represent probabilities, not guarantees, as the study's authors emphasize. Even when there is an 80% chance of a decline exceeding 40% within the next two years, there remains a 20% possibility that the industry will continue outperforming the broader market.

‍

A real-world example of this phenomenon can be observed in the stock performance since mid-April, when I last discussed the implications of the professors' bubble study. At that time, one of the standout stocks was Nvidia, which has continued its impressive upward trajectory since then, gaining about 40%, according to FactSet. On the other hand, Super Micro Computer, which had outperformed even Nvidia in its trailing two-year return as of mid-April, has seen a dramatic reversal in fortune, losing more than half of its value since that time.

‍

This disparity in performance highlights the inherent risks involved in investing in stocks from high-flying industries. While some stocks may continue to rise, there is a disturbingly high probability of significant losses, especially when these stocks have already experienced such dramatic outperformance relative to the market. In this sense, buying into these stocks can feel akin to playing Russian roulette with your investments. While there is a chance of continued gains, the potential for substantial losses is far from negligible. As a result, purchasing these stocks bears more resemblance to gambling than it does to traditional investing.

‍

As we approach the third-quarter earnings season, analysts are closely monitoring these industries, and certain stocks stand out—both in positive and negative ways. Some companies have gained favor with analysts, while others are seen with growing skepticism. Investors looking to navigate these high-risk sectors should exercise caution and scrutinize the fundamentals behind stock price movements, especially when industries have significantly outpaced the broader market in recent years.

‍

A table listing specific stocks within the semiconductor and home-building industries shows those that have outperformed the market by at least 100 percentage points over the past two years. The companies are ranked in descending order based on their trailing two-year alpha. This list serves as a warning to investors—while these stocks have been riding high, they may be vulnerable to significant corrections. As the research suggests, buyer beware.

‍

The patterns seen in these industries align with historical precedents of bubbles. Bubbles tend to form when exuberant investors drive prices higher without sufficient regard for underlying fundamentals. Over time, the inflated valuations become unsustainable, leading to sharp price corrections. The semiconductor and home-building sectors have been among the top performers in recent years, fueled by factors such as strong demand for technology and a booming housing market. However, the same forces that propelled these industries may also make them susceptible to the types of declines highlighted in the academic study.

‍

For instance, the semiconductor sector has benefited from global supply chain disruptions and increased demand for chips, driving company profits and stock prices upward. But as supply chains normalize and demand growth slows, these companies may face headwinds, leading to potential pullbacks. Similarly, the home-building industry has enjoyed a surge in demand due to low mortgage rates and a strong housing market. Yet, rising interest rates or shifts in consumer spending could trigger a downturn, particularly if the market begins to view current valuations as overly optimistic.

‍

In conclusion, while the semiconductor and home-building industries have been stellar performers, their strong two-year alphas raise concerns about potential bubbles forming. The findings from the "Bubbles for Fama" study suggest that these industries may face a high probability of sharp declines in the coming years. While not inevitable, these risks underscore the importance of cautious investing, particularly in sectors where valuations appear stretched.

‍