Happy Anniversary - To a Bursting Bubble

By Tom Beilstein, CFA
Portfolio Manager

Remembering the last five years

This time of year, we hear about a number of college basketball teams that are “on the bubble.” This refers to teams that may or may not make the NCAA tournament, which is the pinnacle of the college basketball season. When a team fails to make the tournament, their bubble is said to have burst. Five years ago, as investors, we were all on the bubble and, unfortunately, our bubble also burst. On March 24, 2000, the S&P 500 reached its apex, closing at 1527.46, a level we have not seen since. For the next two and a half years, the market went on a steady decline, hitting its low on October 9, 2002, some 49% below its high. The market has rebounded nicely since late 2002, with the S&P 500 closing at 1171.42 on March 24, over 50% above its low, yet still 23% below its peak. This example is even more pronounced when we look at the NASDAQ instead of the S&P 500. On March 10, 2000, the NASDAQ, which is heavily weighted in technology issues, closed at 5048.62. By late May of 2000, the NASDAQ had fallen 40% and reached its low in October 2002 of 1108.49, some 78% off its high. The NASDAQ has also rebounded nicely and sat at 1991.06 on March 24, which was 80% above its low yet still a whopping 60% off its high.

Why did it happen?

In short, the market got ahead of itself. From March 1995 to March 2000, the NASDAQ returned approximately 475%, or over 40% per year. These returns were simply not sustainable. To understand how far “out of whack” the market was in 2000, we will look at a couple of stocks. From March 1995 to March 2000, Intel returned 965%, which is around 60% per year. Its P/E ratio reached a high of 63 in 2000, substantially higher than its average P/E in 1995 of 16. Cisco, another technology bellweather stock was up 3020% from March 1995 to March 2000, approximately 100% per year. Its P/E, which averaged 33 in 1995, rose to an incredible 196 in 2000. These multiples are laughable in hindsight, yet seemed reasonable compared to some highfliers such as Yahoo!, which had a P/E of 350, JDS Uniphase, which had a P/E of 557, and Veritas, whose P/E reached 4931, not to mention a multitude of companies that were not yet making a profit. As Fed Chairman Alan Greenspan put it, investors had certainly reached a level of “irrational exuberance.” Most of this “irrational exuberance” has filtered through the market, albeit in a very painful manner, over the past five years. Stocks like Intel and Cisco now have more “normal” P/Es of 21.1 and 22.5, respectively, and the NASDAQ as a whole has a P/E of around 30. This is very important, because with P/Es in their “normal” range, we can expect earnings growth to be the main driver of stock prices going forward.

Where are we now?

Although it may not feel like it, we are just about where we should be. If we focused on the last ten years rather than the last five, we would see that the markets earned favorable returns. Historically, going back to 1925, the U.S. equity markets have averaged approximately 10%. Over the past 10 years, the S&P 500 returned 11.31% and the NASDAQ Composite returned 9.96%. So, the markets are near the levels investors should have expected them to be ten years ago, they just did not take a linear route in getting there. This is one reason we believe in rebalancing. Every investor who rebalanced back to their target percentages on a regular basis probably reduced their equity exposure when the bubble burst. Of course, they missed out a little on the upside, yet they significantly reduced their pain on the downside.

Conclusion

The run-up in the market prior to 2000 gave investors a false sense of security and made them feel that they were wealthier than they truly were. The correction that began in 2000 and lasted for two and a half years brought everyone back to reality. History demonstrates that equity markets are not just driven by earnings and balance sheets, but also by human behavior. This factor fluctuates in a manner that can not be quantified and will again lead us into periods when the market is either over or undervalued. The most important thing is to never lose track of your long-term goals. If you get ahead of your goals, ensure that you will remain on track by putting some of this excess in less risky assets. Rebalancing helps accomplish this by selling a portion of riskier, highly appreciated assets and moving it into less risky assets. If a market downturn puts you behind your goals, sit down with your advisor and see if you can handle a little more risk, increase your savings rate, or, if necessary, pare back your goals. Whatever your current situation, the markets are reasonably valued. The P/E of the S&P 500 currently stands at 17.5, only slightly above its average P/E of 16 ten years ago. This is a very good time to sit down and review where you are, because we are neither at a market peak nor trough. Hopefully in 2015, we will be able to look back at ten more years of competitive stock market returns.

Sources: Ned Davis Research, Baseline, Morningstar