On April 23, 2015 the Nasdaq Composite climbed for the first time above the level that was reached right before the burst of the dotcom bubble in March 2000. Are we again on track for a bubble in the tech sector?
A bit of history: the dotcom bubble
In 1999-2000, the Nasdaq Composite, which reflects the value of all securities quoted on the Nasdaq, witnessed a speculative bubble: in the first quarter of 2000 alone, the index rose by close to 25%, an amazing growth that was not supported by stronger fundamentals of the underlying firms.
A very clear example of the increase in price not related to strong business model or commercial strength is the case of eToys in comparison with Toys "R" Us. eToys was a tech company that IPOed in 1999 and that sold toys through an online platform. It therefore competed with the more traditional player of toys selling, Toys "R" Us.
In 1999, Toys "R" Us had sales 373 times higher than eToys, and made large earnings whereas eToys made losses almost equal to its sales. Nevertheless, eToys enjoyed a valuation 25% higher than Toys "R" Us'. In 2002, eToys went bankrupt, and Toys "R" Us ended up with the domain name "etoys.com". A lot of firms on Nasdaq at that time were in a similar situation: widely overvalued but actually unsustainable because of a flawed or weak business model.
When investors understood that their euphoria toward tech companies had created a huge "irrational exuberance", the Nasdaq Composite plunged and its value was divided by more than 4 in two years.
The Nasdaq: 2000 versus 2015
Source: Yahoo Finance
The graphic shows quite clearly that the progression over the last two years has been more regular and slow than it was the case back in 1998-2000, when the tech bubble was growing. It already gives a reassuring view on today's Nasdaq.
Sources: Own calculations (xlsx), data from Yahoo Finance
Statistics on the two periods covering the two years before each peak show us once again that today's situation is much healthier than in 1998-2000: the average return of Nasdaq has been divided by 2.4, and the risk associated to Nasdaq as measured by the Standard Deviation has decreased by 50%.
The convergence of Nasdaq's returns and risk with S&P 500's also support the thesis that there might not be a bubble. Indeed, the gap in average return has been divided by 5.4 between the two periods. The gap in standard deviation has also dropped: Nasdaq's was 40% higher than S&P 500's in 1998-2000, but is only 15% bigger over the last two years.
This decrease in risk seems very real, as the LPM (lower partial moment), which focuses on negative movement of the volatility, also came down between the two periods for Nasdaq, converging toward S&P 500's LPM. Finally, the beta of Nasdaq in respect to S&P 500 also decreased significantly, going from 1.22 to 1.08 (99.9% significance level; R-squared 73% and 86% respectively).
This overview of the Nasdaq Composite strengthens us in the belief that it is far from being in a bubble situation. We might also be able to find some pieces of evidence to definitely establish that, by looking at the companies that compose the Nasdaq.
More diversity, stronger fundamentals
Let's first focus on the sectorial composition of the Nasdaq: historically, this stock exchange is the harbor of most US tech companies, which is pretty logical, considering that it was the first stock exchange to adopt a fully automated quotation process. Tech companies represented about 57% of the aggregated market capitalisation of all Nasdaq companies in 2000. This number was brought down to 44% in 2014.
This diversification of Nasdaq, in particular expanding toward Consumer Services and Health Care, helped bring down the risk of the index, even though these sectors, in particular Pharmaceutical, are quite volatile.
Sources: David Krein and Jeffrey W. Smith, "The Nasdaq Composite Index, A Fourteen-Year Perspective",SEC fillings
The two previous tables show us the biggest firms of Nasdaq by market capitalisation. We first notice that only four firms from the first ranking made it to the second: Microsoft (NASDAQ:MSFT), Cisco (NASDAQ:CSCO), Qualcomm (NASDAQ:QCOM) and Intel (NASDAQ:INTC). We also note that the weight in the Nasdaq Composite of the biggest firms has decreased, but that the bottom of the top ten had a higher weight in 2014 than in 1999. Thus we can see that the biggest firms are more homogeneous, and that it is not only a few firms that dominate the whole index.
Secondly, it is striking to see the difference in trailing P/E ratios (Price over Earnings): the highest P/E in 2014 for the top 10 firms was the 71.1 of Facebook (NASDAQ:FB), which does not stand the comparison with the 1779.7 of Yahoo (YHOO) in 1999. The same goes with the trailing P/S ratios (Price over Sales), which have dramatically decreased over the period. It shows that the valuations of the companies are much closer to their economic fundamentals today than they were during the tech bubble, which comforts us once again in the idea that today's 5000 points of the Nasdaq actually reflect true economic value.
We must be careful with the huge weight of Apple (NASDAQ:AAPL), which has increased since the previous table was created. It represents today about 14% of the Nasdaq Composite, with the highest worldwide market cap of $725bn. Such a weight in an index could create big discrepancies. However, Apple does not appear to be overvalued as its P/E ratio is one of the lowest among the top 10 stocks of Nasdaq.
Looking at the bigger picture: a better governance
To definitively conclude on this topic, we also need to take a look at the institutions and at the quality of the corporate governance.
It probably does not bring happy memories to any investors to see WorldCom in the highest market capitalizations of Nasdaq in 1999 in the previous table. WorldCom cheated and reported false income for years. It is one of the biggest accounting and auditing scandals that led the American Congress to pass the Sarbanes-Oxley Act in 2002.
Thanks to this law, the quality of the information disclosed to the market has greatly improved, and so did the corporate governance due to the greater transparency, and the better control by auditors. A good quality of information is a primordial element to avoid bubbles. Indeed, unreliable information or high asymmetry of information can lead investors to have misrepresentations of reality. For example of what is happening in a sector, or how much a firm is actually worth.
However, the Sarbanes-Oxley Act did not fix everything, and recent regulations even went in the opposite direction: the 2012 JOBS (Jumpstart Our Business Startups) Act eased significantly the disclosure requirement and regulations for "emerging growth companies" and startups: during the first 5 years after the IPO, the company benefits from lower disclosure requirements. It mainly cancel dispositions introduced by the Sarbanes-Oxley Act. The advocates of the JOBS Act are glad, as the number of IPO strongly increased over the last years. But we do not yet see the full extent of the damage caused by the higher opacity of young firms and possible lower governance standards.
This is all the more important that merger and acquisitions intensified a lot over the last years. Not only did the absolute number of M&A deals increase, but also the size of those deals, a phenomenon especially noticeable in the Tech sector. The more information investors can access, the more accurate their valuations, and therefore the lower the risk of speculative bubble. Regulators should pay a particular attention to enhance the quality of disclosure rather than easing disclosure requirements.
- Nasdaq is definitely not in a situation of bubble. In fact, it is much healthier than it was fifteen years ago. Tech firms have better business models, larger sales, larger earnings and dividends, not to mention buybacks. Investors are more knowledgeable about Internet and new technologies, leading to more accurate valuations.
- We expect Nasdaq to follow a bullish trend in the medium run, driven by the growth of big companies generating large sales and earnings. Apple will be leading the pack, which is good news: earnings have never be so high, and the forward guidance is very encouraging as well.
- The main risk factor in the short run might well be the bubble growing in China on Tech firms (mainly on Shanghai and Shenzhen stock exchanges) which could have negative repercussions on Nasdaq Composite when it will burst, but Nasdaq could actually benefit from the shock if foreign funds invested in China and HK were to fly back to the US.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.