What Bonds, Oil, and Small-Caps Say About NVIDIA’s Future

Key Points

• Connecting the dots between different asset classes and specific stocks might spell out trouble for investors moving forward in the S&P 500.
• Looking at the way bonds and oil have behaved recently should give a clear answer of what comes next.
• Small cap stocks, and a rotation into them, might be the best course of action here.

Today’s stock market is as different as it can be from the one that most investors are used to seeing in the past. The new market regime requires participants to be more aware of what is happening everywhere, lest they miss out on life-changing opportunities or overstay their welcome when things are going well and give up most (if not all) of their gains back to the marketplace.

The true way to stay in sync with the market is not by watching and understanding one market closely every day, such as the S&P 500 or other stocks, but by keeping track of what other asset classes are doing and the message being developed in terms of narrative. Without this understanding, investors might fall into the daily whipsaws and temper changes the market is known for having.

Knowing this, investors can do a deeper dive into the S&P 500 index, especially in names within the technology sector like NVIDIA Co. NASDAQ: NVDA compared to small-cap stocks in the iShares Russell 2000 ETF NYSEARCA: IWM, or how bonds and commodities have behaved recently amid recent volatility and economic uncertainty. After this analysis, a clearer picture and plan of action should guide investors through this market.

To Chase NVIDIA or Not to Chase

Most investors are still fascinated by NVIDIA's rise (and rise). During cycles like this one, complacency tends to grow most, and risk management or worst-case scenarios simply become an afterthought. By bringing those important factors back to the front of the row, investors can see a subtle warning sign.

NVIDIA’s price action and forward P/E ratio don’t match anymore, at least not as much as they did during the stock's multi-year rally.

Understanding that a forward P/E is the market’s way of pricing in tomorrow’s earnings per share (EPS) growth, this should spell trouble for investors.

Losing confidence in tomorrow’s earnings will eventually show up in the stock price, and that’s not to say investors should leave NVIDIA.

Still, maybe they should consider other areas of the stock market. 

One of them is the iShares Russell 2000 ETF, which arguably provides a much better risk-to-reward setup.

By underperforming NVIDIA and the broader S&P 500 index, small-cap stocks offer a chance to catch up to the momentum seen in equities or otherwise offer a much smaller sell-off if things turn sour.

However, that belief has to be justified in other markets as well.

What Bonds Are Telling Investors

If anyone had invested in the iShares 20+ Year Treasury Bond ETF NASDAQ: TLT 12 months ago, they would be down 7.5% and missed out on the massive rallies seen in some stocks during that time. However, complacency would ignore the fact that as bond prices come down, their yields consequently start to rise.

With the United States ten-year bond yield closing above 4.5% again, stock market valuations have to find new justification to stay as high as they are today. Taking NVIDIA as an example, higher yields (more expensive money and tighter financing) might negatively affect the company’s future earnings.

That might explain why the market is discounting its forward P/E today, understanding that NVIDIA’s customers might cut back on capital expenditures and expansion plans as the money and credit markets tighten due to rising bond yields.

Following this dynamic starts to paint a clearer picture for investors trying to come up with a game plan, but there are other signs in the market that also point to a potential slowdown coming up, threatening not only NVIDIA’s but also most large-cap future earnings.

Oil Prices: The Difference Maker

Some might argue that bond yields can also go up because of future inflation, and that is not a wrong assumption. However, with inflation typically comes more business and consumer activity, which creates demand for one common factor across the board. That factor is the energy sector, which should be reflected in energy prices.

When investors see the massive underperformance in the price of oil or a proxy within the Energy Select Sector SPDR Fund NYSEARCA: XLE, which underperformed the S&P 500 index by up to 20% over the past 12 months, there seem to be no signs of the market screaming at more business or consumer activity in the future.

All told, investors might expect that tight monetary environments (due to high bond yields) might have to reverse their path to accommodate more business and consumer spending, which should then be reflected in oil prices.

At the end of that “green light,” there should be a rotation out of some of the more expensive names in the S&P 500 and into smaller businesses, which typically see the benefits of lower bond yields and accommodative money markets before anyone else does.