The Fear Mongers Just Can’t Help Themselves
Apples and Oranges
On Monday, the Nasdaq Composite Index hit 5000 for the first time since March 9, 2000, and the fear mongers just could not help themselves. They had to once again make a completely irrational historical comparison that bears no significance whatsoever to today’s equity market.
The chart below explains why the media became so fixated on this “historic” event. The last time the index exceeded 5000, it then fell 78% through late 2002, as the technology bubble burst.
Source: Reuters
Fear mongers are using some pretty simplistic logic to explain why they expect a repeat crash. They believe that since the market crashed the last time the index surpassed 5000, history will repeat itself, particularly since valuations on equities in the index appear to be stretched in the eyes of some.
There are so many flaws in this argument that it’s tough to decide where to begin, but let’s start by focusing on inflation, since it immediately invalidates the argument above. To compare apples to apples, one must incorporate the effects of inflation over the past fifteen years. Doing so would require the index to be closer to 7000 to make a truly accurate comparison (based on an average annual inflation rate of 2%).
However, even if we ignore the obvious need to adjust the index for inflation, the irrationality of comparing today’s Nasdaq Composite against the dot-com era runs deep for three key reasons.
First, the composition of the index has changed dramatically over the last 15 years. In 2000, the Nasdaq Composite tracked mostly younger companies that were concentrated in high growth sectors such as technology, telecom, and biotechnology.
These nascent sectors posed far greater risk when compared to other more established sectors and companies that were profitable with experienced management teams. When the internet bubble burst, the index was ultimately decimated because so many of its constituents were too young and ill-equipped to withstand an economic downturn.
Today, the Nasdaq Composite represents far more diversity with respect to sector, company size, and average life. For example, the average company in the Nasdaq Composite in 2015 has been in business for 25 years, up from 15 in 2000.
Next, the fundamentals of the companies in the Nasdaq Composite are far better now than during the tech boom. Back then, close to 30% of companies in the index had next to no earnings and/or sales. Today, the index represents companies that have strong profits and enough cash flow to even pay dividends in many circumstances.
Lastly, valuations are nowhere near as stretched as they were during the dot-com era. The price-to-earnings ratio (P/E) of the index is currently around 21.5x, which admittedly is higher than its historic average. However, back in 2000, the Nasdaq Composite’s P/E reached 175x, or over eight times greater than today.
Let’s use Commerce One as a prime example of the absurdity around valuations back during the tech boom. This company was one of the early dot-com “darlings”, and at its peak fetched a market value of $21.5 billion despite having only $33.6 million in sales in 1999 and no earnings.
When companies have no earnings, investors cannot use P/E ratios (the math won’t allow a zero in the denominator of the ratio) and usually use the price-to-sales ratio (P/S) instead.
NOTE: Younger companies with very high growth potential often operate for many years without generating earnings because management teams are taking all of the profits and reinvesting back into the business to continue its growth. At this stage, investors are buying stock in these companies because of their ability to generate sales growth, not earnings growth, and therefore the P/S ratio is a more valid relative measure versus the P/E ratio.
For the sake of comparison, a stock that trades over 20x sales is considered to have a very high valuation and faces tremendous downside risk if the sales growth were to slow.
Right before the bubble burst, Commerce One traded at over 600x sales ($20 billion divided by $33 million), which is 30x higher than some of the highest multiples today! Simply put, the hype surrounding the high growth companies in the Nasdaq Composite is nowhere close to where it was back then.
Implications for Investors
The tech bubble did not burst in 2000 because the Nasdaq Composite Index reached 5000. It plunged because the companies in the index could no longer support such meteoric valuations when investors started to realize that real growth would fail to materialize in a highly concentrated sector (internet technologies) within our economy.
I am not implying that the Nasdaq Composite is cheap today relative to past markets. Given current valuations and growth prospects, I would argue that it’s neither cheap nor expensive. There’s no question that Fed stimulus and cheap debt have provided a boost to the value in the index, along with other popular equity indices, but going forward I expect to see sales growth and earnings be the catalyst for future growth.
The bottom line is that history often does repeat itself, but usually only when similar situations arise. Today’s Nasdaq Composite and economic environment are entirely different than prior to the tech bubble exploding, so investors should ignore the commentary in the media and remain focused on the economic data that continue to support our rising equity market.
