Stocktake: Bubble talk premature despite frothy prices


Talk of a tech bubble is everywhere at the moment. The Nasdaq is above 4,000 for the first time in 13 years; social media stocks like Twitter, LinkedIn and Facebook are at sky-high valuations; Snapchat has reportedly turned down a $3 billion takeover offer despite an unproven business model and no revenues.

And that’s about it, really. Comparisons with the dotcom era are as ludicrous as they are common. Yes, social media valuations defy logic, and some tech stocks like Amazon are expensive. Others, like Apple, Microsoft, Cisco and Intel, sit on a mountain of cash and trade at 11-12 times estimated earnings.

It took almost a year for the Nasdaq to go from 3,000 to 4,000. In November 1999, it went from 3,000 to 4,000 in a month, topping out above 5,000 in March 2000.

The tech sector accounted for 13 per cent of the S&P 500 in early 1998; by March 2000 its sector weighting had soared to 33 per cent. Today it accounts for 17.6 per cent of the index, compared to 17.8 per cent at the start of the bull market in March 2009.

This year the Nasdaq 100 is up 32 per cent, not much more than the S&P 500’s 26 per cent return.

Technology may be overbought and it may be overvalued, but a bubble? No chance.

S&P 500 gain not extraordinary
Bubble talk is not confined to tech. A survey of Bloomberg subscribers found 20 per cent thought global stocks are in a bubble; another 45 per cent thought they were near bubble levels. This is peculiar – although the MSCI World Index has risen 21 per cent this year it remains near historic valuation levels.

The S&P 500 is clearly overvalued, having soared by 170 per cent since March 2009, but bubble talk is a bit wild. This year’s 26 per cent gain, though the highest since 1998, is not extraordinary.

Over the last 86 years the S&P 500 has risen by at least 25 per cent on 24 occasions. Annual gains of 20 to 25 per cent have been the second most frequent outcome for the index since 1927.

Marketwatch’s Mark Hulbert notes that in December 1999 the index had a price-earnings ratio of 29.7 (19.1 today); a cyclically adjusted price/earnings ratio of 44.2 (24.4 today); a price/book ratio of 5.1 (2.6 today); and a price/sales ratio of 2.4 (1.6 today). Valuations are high, not stratospheric.

Double-digit gains have followed returns of 25%
Whether US stocks eventually hit bubble levels is another matter. Jeremy Grantham recently warned that, although the S&P 500 is well above fair value, he would not be surprised if it rose another 20 to 30 per cent in the next year or two, followed by the third major crash since 2000.

He may be right. LPL Financial Research last week noted that one-year returns of 25-30 per cent have been followed by double-digit yearly gains on four out of five occasions. Yearly gains of 20-25 per cent were followed by an average gain of 14 per cent the next year.

Valuation concerns may not deter bulls. JP Morgan notes that bull markets – beginning in 1982 and 1990, after they reached average price/earnings ratios – were followed by gains of 49 per cent and 83 per cent respectively.

Morgan Stanley also notes there have been only three occasions over the last four decades that earnings multiples rose so much over a two-year period. Each time markets continued to rise for at least another year.

Unhappy with euphoria
Not all signals favour bulls. Stocktake recently noted that Citigroup’s Panic/Euphoria model – a contrarian indicator designed to identify excessive bullishness or bearishness – was just shy of euphoria levels.

Not any longer. It’s been in the euphoria zone for two consecutive weeks now, matched by increased money flows.

“Euphoric sentiment raises deep concern,” said Citi, history indicating an 83 per cent probability of market losses over the next year.

Buyers of cheap stock have history on their side
Dublin-based Covestone Asset Management aims to beat global market returns by 3 per cent annually. That’s ambitious – Covestone acknowledges up to 90 per cent of active managers underperform – but it points to the historic outperformance of value strategies.

Since 1990 the cheapest decile of global stocks outperformed the most expensive by almost 7 per cent. Value stocks particularly outperformed in Europe; the cheapest 20 per cent of stocks based on price/earnings ratios beat the market by 0.41 per cent per month since 1990 (0.18 per cent in the US), while the cheapest based on cash flow yield returned an extra 0.78 per cent monthly (0.42 per cent in the US). Using dividend yields and price/book ratios to determine value delivered similar outperformance.

Much has changed since 1934, when the father of value investing, Benjamin Graham, wrote Security Analysis. However, the basics remain the same: “If one buys cheap stocks, one tends to do well,” says Covestone.

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