Don't Fear Today's Stock Market: It's No Late '90s 'Bubble'
We’ve enjoyed an eight-year bull market, but bears warn that we are in bubble territory. Is it time for value investors to bail? Nope.
Let’s remember what a real bubble looks like.
Back in the 1990s, when computers and cell phones were just starting to take over our lives, the spread of the Internet sparked the creation of hundreds of Internet-based companies, popularly known as dot-coms. In too many cases, the idea was simply to start a company with a dot-com in its name, sell it to someone else, and walk away with pockets full of cash. It was so Old Economy to have a great idea, start a company, make it a successful business, and turn it over to your children and grandchildren.
If you already had a company, you could double its value by adding.com, .net, or Internet to its name. Money for nothing!
A dot-com company proved it was a player by spending money, preferably other people’s money. (I’m not joking, but I am laughing.) The idea was to be the first-mover by getting big fast (a popular saying was “Get large or get lost.”). Once people believe that your web site is the place to go to buy something, sell something, or learn something, you have a monopoly that can crush the competition.
It is not a completely idiotic idea. It sometimes even works. (Think Amazon.) The problem was that there were thousands of dot-com companies and there isn’t room for thousands of monopolies.
Most dot-com companies had no profits. So, wishful investors had to think up new metrics for the so-called New Economy to justify ever higher stock prices. Instead of being obsessed with something as old fashioned as profits, we should look at a company’s sales, spending, web-site visitors. Companies responded by finding creative ways to give investors what they wanted. Investors want more sales? I’ll sell something to your company and you sell it back to me. No profits for either of us, but higher sales for both of us. Investors want more spending? Order another thousand Aeron chairs. Investors want more web-site visitors? Give stuff away to people who visit your web site. Buy Super Bowl ads that advertise your web site. Two dozen dot-com companies ran ads during the January 2000 Super Bowl game, at a cost of $2.2 million for 30 seconds of ad time, plus the cost of producing the ad. Companies didn’t need profits. They needed traffic.
One measure of traffic was eye-balls, the number of people who visited a page; another was the number of people who stayed for at least three minutes. Even more fanciful was hits, the number of files requested when a web page is downloaded from a server. Companies put dozens of images on a page, and each image loaded from the server counted as a hit. Incredibly, gullible investors thought this meant something important.
Stock prices tripled between 1995 and 2000, an annual rate of increase of 25 percent. Dot-com stocks rose even more. The tech-heavy NASDAQ index more than quintupled during this five-year period, an annual rate of increase of 40 percent. Someone who bought $10,000 of AOL stock in January 1995 or Yahoo when it went public in April 1996 would have had nearly $1 million in January 2000.
In 1999, a small Internet company called NetJ.com filed an SEC statement that was brutally candid: “The company is not currently engaged in any substantial business activity and has no plans to engage in any such activity in the foreseeable future.” The price rose from $0.50 a share to $3.50 a share in six months. A company that doesn’t do anything or plan to do anything was valued at $22.9 million, not much for a real company, but a lot for a do-nothing company.
In March 2000, the Wall Street Journal ran a front-page story about Bill’s Barber Shop in Dennis, Massachusetts, a shop I’ve been to, where the locals talked about dot-com stocks while they watched stock prices dance on television. One regular said that, “You get three or four times in your life to make serious bucks. If you miss this one, you’re crazy.” Another agreed, “I don’t think anything could shake my confidence in the market. Even if we do go down 30%, we’ll just come right back.”
Dot-com entrepreneurs and stock market investors were getting rich and they wanted to think it would ever end. But, of course, it did, because there was nothing to justify lofty prices beyond dreams that prices would go higher still. When prices stopped going up, they came down fast.
After the bubble popped, the Journal made another visit to Bill’s Barber Shop. Bill was now 63 years old and his retirement portfolio had been decimated. His $834,000 was down to $103,000, which was $50,000 less than his initial investment: “It means that I’m looking at another 10 years of work, instead of being retired.” Bill had given up playing the stock market. Now, he was playing blackjack and poker at a Connecticut casino: “I do better there than I do in the market.” Which isn’t saying much. Sort of like being the world’s tallest midget.
Need I say that things are very different today? There are inevitably some stocks that make you wonder but, overall, the traditional valuation metrics indicate that this is no bubble. Dividends and earnings are strong and interest rates are low. Investors aren’t making up fanciful metrics to justify delusions.
John Burr Williams, the original value investor, developed this simple investment benchmark:
Total Return = Dividend Yield + Dividend Growth rate
In March 2000, near the peak of the dot-com bubble, the S&P 500 dividend yield was 1.16 percent. Adding in a 5 percent long-run growth rate for dividends, the predicted total return is 6.16 percent:
Total Return = 1.16% + 5% = 6.16%
Which was lower than the 6.26 percent return on ten-year Treasury bonds. Earning less than Treasury bonds with a lot more risk is not appealing.
Today, in contrast, the S&P 500 dividend yield is 1.91 percent, and a 5 percent long-run growth rate gives a 6.91 percent predicted total return:
Total Return = 1.91% + 5% = 6.91%
Wwhich is 4.70 percentage points above the 2.21 percent return on ten-year Treasury bonds.
Other fundamental valuation metrics come to the same conclusion. Long-term investors can anticipate an annual 6-to-8 percent return on the S&P 500, well above the return on long-term Treasury bonds.
I don't know whether stock prices will be higher tomorrow, or next week, or next month than they are today, but I do know that, for a value investor taking the long view, stocks are not expensive.