This Is What a Stock Market Bubble Looks Like
Editor’s Note: Today, we are excited to share a piece from award-winning financial journalist Aaron Task. You may know him from his work at Fortune and Yahoo Finance. He is currently attending our annual Investment U Conference in St. Petersburg, Florida. Below, he shares some insights from the big event... and why the mood among attendees and presenters is so overwhelmingly positive.
The annual Investment U Conference kicked off Wednesday, and watching the presentations from Alexander Green and others, I was struck by the overriding sense of optimism and opportunity. It’s quite different from most of the financial commentary you hear these days, which is mostly about how the world is about to end - at least for investors.
So I thought it would be interesting to compare today’s market to the 1990s dot-com era, which pretty much sets the standard for a modern stock market mania.
The comparison is even more compelling because this month marks two major milestones for the stock market:
- March 8 was the eight-year anniversary of the start of the current bull market, which has sent major averages surging to record highs, sending the Dow above 21,000 and the S&P 500 above 2,400 at their recent peaks.
- March 10 was the 17-year anniversary of the peak of the 1990s dot-com boom, when the Nasdaq breached 5,000 for the first time. After the tech bubble burst, it took more than 15 years for the index to get back to 5,000 (and now beyond).
These two milestones are important because there are a lot of comparisons between today’s market and the go-go 1990s. But just because the stock market is up a lot - about 250% from its March 2009 lows and more than 10% since Donald Trump’s victory - that does not mean it’s in a bubble.
Let’s talk about valuations. If you follow the financial media, you’ve probably heard about P/E ratios and the so-called Shiller P/E, or CAPE (cyclically adjusted P/E ratio). Created by Yale professor Robert Shiller, CAPE measures the market’s valuation based on inflation-adjusted earnings for the past 10 years. The idea is to smooth out one-time events (good and bad) that can warp the numbers.
And on that Shiller P/E basis, today’s market is expensive. In fact, it’s the third most expensive the market has ever been. But here’s the rub... The stock market was 44% MORE expensive on this basis back in early 2000.
One more (big) factor that’s often overlooked by the talking heads and the doomsayers is the value of stocks relative to bonds. The earnings yield of the S&P 500 (the inverse of its P/E) is currently 3.75%, not far from where it was in early 2000.
The kicker? Back then, the 10-year Treasury was yielding a devilish 6.66% vs. a mere 2.50% today.
In other words, investors are being rational today by betting on stocks when bond yields are so relatively paltry. By contrast, stocks were dramatically overvalued compared to the risk-free return offered by bonds back in 1999 to 2000, and yet all anyone wanted were stocks.
Let’s take this comparison a step further. Below are charts showing the valuations of the top five biggest tech companies by market cap today and the top five from March 2000.
First, a straight comparison of P/E ratios now vs. then for the big tech names...
As you can see, with the notable exception of Amazon.com (Nasdaq: AMZN), today’s tech leaders are not nearly as expensive compared to the champions of 2000. And the average P/E of today’s tech giants is about half of what it was for their counterparts, circa 2000.
Rephrased since we say "But here's the rub" a few paragraphs above. Not a huge deal, but it seemed a little repetitive.
Next, we look at the same comparison on a price-to-sales basis, which focuses on a company’s revenue vs. its earnings, which can be manipulated... umm, managed by legal if dubious accounting maneuvers.
Here we find an even more extreme gap between the valuations of the dot-com era and today, where the average P/S of the five biggest tech companies is 6.62 versus a whopping 20.57 back in 2000. And today’s most expensive tech giant, Facebook (Nasdaq: FB), trades with a price-to-sales ratio less than the average of the top five from 2000.
This is a small sample set, but it gives a snapshot of what a real market mania looks like. And speaking of snaps (segue!), there’s been a lot of talk about the Snap Inc. (NYSE: SNAP) IPO and how its first-day gain of 44% is another sign that investors have lost their collective minds. Now, I’m not here to tell you that Snap is a value stock by any means, but consider this: The top 10 IPOs of 1999 saw first-day gains ranging from 313% to 525%, according to Hoover’s.
And you probably recall Pets.com, but a lot of companies that didn’t even have as much as a sock puppet went public in that era, when companies were valued on “eyeballs” and other totally made up... um, nontraditional metrics.
That, my friends, is what a bubble looks like.
Differences From the Dot-Com Bubble
The dot-com bubble wasn’t the only big financial collapse of the early 2000s. Enron and WorldCom were exposed participating in systematic accounting fraud within two years of the Nasdaq crash.
In the aftermath of these accounting scandals, Congress passed the Sarbanes-Oxley Act (SOX). It increased regulations and reporting requirements for public companies.
As The Oxford Club’s friends at Early Investing will tell you, SOX created some problems of its own by locking retail investors out of early-stage tech startups. In doing so, however, it also protected public financial markets from the kind of fraud and deception that enabled the dot-com bubble.
SOX might have been unduly restrictive, depending on who you ask. But it also ensured that not just anyone can found a phony tech company and reach an IPO with it.
In other words, some of the most ridiculous companies to rise and fall in the dot-com bubble could not go public in today’s Silicon Valley. Pixelon, for example, was a hot ‘90s tech stock representing a fabricated video streaming company with nonexistent core technology. Its CEO was a convicted felon using a fake identity.
Some of today’s tech “unicorns” might not justify their heady valuations, but you can rest assured that a total scam company like Pixelon wouldn’t fly today.
As Alex Green wrote last summer, bubbles have two universal characteristics: sky-high valuations and a euphoric outlook. Today’s valuations are high, but they’re not extreme when compared with the dot-com era. And most people remain more fearful than euphoric when it comes to stocks, which is understandable, but also undermines the comparison to the tech bubble - when everyone and their Uncle were day trading, and stocks became the national pastime.
Having said all this, I’m not going to sit here and say that today’s market is cheap - as mentioned above, the current CAPE ratio is the third-highest in history. At a minimum, that suggests returns for the next 10 years should be lower than the market’s historic average of around 7%. But that doesn’t mean the stock market is in a bubble, and it would need to get a lot more expensive (and nutty) to be anything remotely like the late 1990s boom.
Just something to keep in mind the next time you hear someone yelling “bubble” in a crowded cocktail party.
(Additional reporting by Samuel Taube)
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