Soaring stocks: is this 1999 redux?

The three main US equity indices recently hit simultaneous record highs for the first time since the dotcom era, but today’s markets are very different in some key respects.

The S&P 500, the Dow Jones Industrial Average and the Nasdaq recently hit all-time highs on the same day. The last time that happened was on New Year’s Eve, 1999, just months before the bursting of the dotcom bubble and a devastating 30-month bear market for stocks. With stocks having advanced more than 20 per cent since February, are markets once again overheating or are comparisons with the late 1990s misplaced?

Simultaneous highs

The recent march to simultaneous new highs may have been the first such occurrence in almost 17 years, but this should not be viewed as some rare historical oddity only seen in excessively exuberant markets. The long gap is explained by the fact that after the late-1990s market boom, Nasdaq went on to fall by almost 80 per cent and did not manage to reclaim its dotcom era highs until 2015.

However, it's quite common for multiple indices to hit new highs at the same time; this happened on 148 occasions between 1983 and 1999, according to LPL Research strategist Ryan Detrick, and on 25 occasions in 1995 alone. Most of the time, stocks continued to advance, with the S&P 500 going on to enjoy median 12-month gains of 17.2 per cent.

In other words, there is no reason to fear a trifecta of index highs; rather, history would suggest it will become an increasingly frequent occurrence in coming years.

Valuation

Only the most hardened bears would dare suggest the S&P 500 is as overvalued now as it was in late-1999/early-2000. A composite of valuation indicators tracked by the Leuthold Group's Doug Ramsey suggests the S&P 500, currently around the 2,200 level, would need to reach 3,455 to match the March 2000 all-time valuation peak. This is "less a testament to the market's potential upside than an illustration of the true insanity of that 2000 peak", says Ramsey. Nevertheless, "there's room" for a market melt-up.

Ramsey’s analysis also suggests investors are right to be cautious about today’s valuations, however – for example, the S&P 500 would need to fall by 22 per cent to trade at its median historical valuation, he says. Some valuation indicators suggest even greater downside is merited. Stocks currently trade on a cyclically adjusted price-earnings (Cape) ratio of 27, compared to a historical average of 16. The Cape is in line with that seen at 2007’s market peak and has only been exceeded on two occasions – at the infamous 1929 and 2000 market tops.

Bulls counter, however, that Cape ratios have risen in recent decades due to structural reasons. According to JPMorgan data, the S&P 500 has traded on an average Cape ratio of 25.4 over the last 25 years, indicating stocks today are only modestly overvalued. Additionally, the S&P 500’s current dividend yield is higher than its 25-year average, while its current price-book and price-to-cash flow ratios are lower than their 25-year average.

Additionally, bulls argue that even if stocks are overpriced relative to history, today’s investors have no alternative to equities, given the rock-bottom bond yields on offer. In contrast, US government bonds yielded 6.5 per cent in early 2000; the very fact dotcom investors ignored these attractive yields and continued to pile into overvalued stock markets is testament to the equity mania that prevailed at the time.

Clearly, comparisons with 1999-2000 valuations are misplaced. Additionally, while today’s valuations look elevated on many metrics, this has been the case for many years now, during which time stocks have continued to climb. Nevertheless, high valuations tend to be followed by lower long-term returns. Concerned long-term investors might thus be minded to rotate out of the US and into cheaper international markets whilst accepting that valuation is of little use when it comes to timing – no one can say when the current run of US outperformance will end.

Market breadth

The dotcom bubble burst in March 2000 but that’s not to say that most stocks peaked in the same month. In fact, many stocks had been declining long before that date. The number of net new highs – the number of stocks setting new 52-week highs minus those setting 52-week lows –had been declining since May 1998. Just 24.5 per cent of stocks in the S&P 1500, a broad index incorporating large-,mid- and small-cap stocks, outperformed the index in 1998 and only 28.6 per cent did so in 1999. Note that over the last two decades, 48 per cent of stocks beat the index in an average year; the 1998 and 1999 figures are far lower than all other years during that period. Strength in the high-flying technology sector was keeping the broader market indices afloat and masking underlying weakness; consequently, the technology sector accounted for 35 per cent of the S&P 500 in March 2000, compared to just 13 per cent in 1998.

Today's situation is completely different, with no one sector driving the gains. Technology is again the S&P 500's largest sector, but its index weighting – 20.7 per cent – has only risen slightly over the last seven years. The financial sector is next, accounting for 15.7 per cent of the S&P 500, roughly in line with its historical average. The number of New York Stock Exchange and Nasdaq stocks hitting net new highs recently hit its highest level in years. At one point last month, 87 per cent of stocks traded above their 50-day average. A multitude of strategists have commented on the improvement in market breadth. In short, the current rally is a very broad-based one that is nothing like the narrow market seen near the March 2000 peak.

Sentiment

Bullish sentiment among ordinary investors, as measured by the weekly American Association of Individual Investors (AAII) polls, reached its highest level in history on January 6, 2000 – two months before the dotcom bubble burst. No such headiness has been evident of late. In fact, bullish sentiment among AAII members has actually been below its historical average for a record 40 weeks in a row. Merrill Lynch’s monthly fund manager survey shows fund managers are similarly cautious, with cash levels hitting 5.8 per cent in July – their highest level in 15 years. Strategists, too, are wary; usually a bullish bunch, the consensus year-end S&P 500 forecast of 21 strategists tracked by Bloomberg is actually below the index’s current price.

It’s often said the ongoing seven-year bull market is the most-hated rally in history and one can see why. The terrible bear markets of 2000-’02 and 2008-’09 left battle-scarred investors wary of stocks. Many investors are reluctant bulls who feel they have been forced into buying equities due to the scarcity of yield available in other asset classes. There is none of the irrational exuberance that characterised markets in 1999-2000, with today’s muted sentiment indicating that there is plenty of life left in the ongoing seven-year bull market.

Pace of gains

Unsustainable bull markets often climax with a so-called blow-off top; does the S&P 500’s 21 per cent advance off its February lows qualify?

Short answer: no. The S&P 500 is up by a mere 5 per cent over the last 12 months and just 12 per cent over the last 24 months, neither of which are indicative of speculative excess. In contrast, the S&P 500 advanced by an incredible 68 per cent between October 1998 and its March 2000 peak.

Nor is there anything extraordinary about the 21 per cent gain over the last six months. Historically, there have been 96 occasions where stocks staged double-digit rallies without suffering a 10 per cent drop, according to a recent Merrill Lynch report; the average gain has been 34 per cent. Gains are even larger in the final double-digit rally during cyclical bull markets, averaging 47 per cent over a 13-month period.

How long can the rally last? Longer.