Lessons From History: 2000
- Comparing the current situation to the past makes sense, as we can learn from past patterns.
- Similar to 2000, we are seeing not only high valuation levels, but valuation tools also being called into question.
- We are witnessing confirmation bias, FOMO, feedback loops as well as Buffett and many other investors being criticized for not understanding how to invest anymore.
- Aside from unrealistic valuation levels and dangerous euphoria, we are also faced with a pandemic and severe recession.
To be honest, I didn't plan to write this article. In my article "Lessons from history: 1929" I looked at - surprise, surprise - the Great Depression and some lessons we can learn from it. And I planned to publish similar articles for other bear markets or recessions, but the Dotcom bubble (and the year 2000) was not one of the times I would have been looking at. I saw some similarities, but in my opinion, the patterns leading up to 2020 were different compared to the patterns leading up to 2000. This was until very recently. What happened in the stock market in the last few weeks during May and also in June might be the Dotcom bubble "in a nutshell" - euphoria compressed in just a few weeks of crazy buying.
And suddenly, it feels like 1999 or early 2000 again. But I have to be honest. My memories of 2000 are shaky - to say it modestly. Back then, I didn't know what a CAPE ratio was, I didn't know Warren Buffett, I didn't know Robert Shiller, I absolutely had no idea how to read a balance sheet. I had no idea what a chart is or how to read it. People bought stocks as they did go up, people didn't understand what they were buying - and I was one of them. However - I was eleven and only in this "game" because of my father. Many important lessons we can learn from the Dotcom bubble and the years around the Millennium often have to do with bubbles, speculation, extreme asset prices, or the fear of missing out, and we start by looking at valuation metrics.
Lesson 1: Valuations Matter
I know that some people might be annoyed by mentioning valuation metrics - and especially, the CAPE ratio - over and over again. But it is a first classical sign that we are near a stock market peak (or even in a bubble) that valuation metrics are called into question for different reasons. We hear stories that investing is different now; it is argued that valuation metrics don't matter anymore, and companies in the 21st century can't be valued accurately any more by looking at these investing tools from the 20th century. This is often combined with some kind of "new era thinking" and the assumption that the economy will grow at much higher rates than in the past, which would justify higher valuations.
The argument is always that these old investing tools (like price-earnings ratio or CAPE) might have been useful in past decades, but can't be used anymore. However, as the chart below is showing, for long-term investors, the CAPE ratio is important as there is a clear correlation between the CAPE ratio and long-horizon returns.
(Source: Advisor Symposium)
Since 2018, the CAPE ratio was above 30 for most of the time, and with the CAPE ratio peaking at 33, the US stock market is trading at its second highest level in the last 150 years (only excelled by the months before the Dotcom bubble burst).
(Source: Advisor Perspectives)
It makes sense to compare the stock market to 1929 as the valuation is similar - see my last article - and it makes sense to compare the US stock market to the Dotcom bubble. At such high valuation levels, the risk of a setback or crash is extremely high.
Aside from the CAPE ratio, we can also look at the forward 12-month P/E ratio, which is often used by analysts. The chart below shows the last ten years, and especially eye-catching are the last few weeks. The forward P/E ratio is shooting up like a champagne cork. As the nominator (the index price) is getting higher and higher, and the denominator (the expected earnings) is getting lower and lower, it leads to a spectacular increase from about 13 in March 2020 to almost 23 in early June.
(Source: FactSet Earnings Insight)
Although valuations are almost useless to time the market, valuations will matter in the long run. When looking at the last three decades, the CAPE ratio for the S&P 500 (SPY) was mostly at high levels (compared to the last 150 years). But, at some point, valuations come down again to more realistic levels - like in 2009, for example. And low interest rates certainly might justify valuations to be a little higher. Maybe the stock market can be seen as fairly valued with a CAPE ratio of 15, and in times of zero interest rates, a CAPE ratio of 18 can be seen as fairly valued. But it is crazy to assume valuations don't matter - it was crazy back in 1999 and 2000, and it is crazy now.
The first lesson is actually pretty simple: Valuations matter today in a similar way as they mattered 20 years ago, and valuations will come down again. What we don't know is, if that happens with a crash lasting just a few quarters or slowly over many years (or sometimes even a decade or longer), but it is dangerous to expect valuations to stay at such higher levels over the long run.
Lesson 2: Analyze The Stocks You Are Buying
When not only looking at the "overall market", but more at individual companies, we see some patterns that are very similar to the late 1990s. 20 years ago, people mostly invested in companies that had "Dotcom" somehow in the name (which led to the name by which this bubble is remembered). 20 years ago, it was basically the IPO of new (and in most cases, worthless) companies that drew investors in. While we are seeing similar patterns as 20 years ago, nowadays, it especially seems to be the penny stocks and bankrupt companies, which are fascinating investors.
(Source: Author's own work created with Google Trends)
While the Google search volume is clearly showing a spike for search terms like "day trading" and "cheap stocks", we are also seeing unrealistic growth expectations driving up prices of individual stocks. While I certainly don't want to compare Tesla (TSLA) to many of the worthless companies that were listed in the 1990s, I think we are seeing at least a similar pattern. In case of Tesla, we don't necessarily have to expect bankruptcy, but a market capitalization of $200 billion seems extreme excessive and does not reflect realistic growth expectations for the company. With a price-sales ratio of almost 7 (with the sector median being 0.78 and even Tesla's own five-year average being only 4.81), a GAAP P/E ratio of 5,570 (no, not a typo!) and even the forward non-GAAP P/E ratio being 230, the valuation seems to be extremely stretched - even for a company with huge growth potential (at least in theory as the demand for high-priced cars might not be so high in the coming quarters with millions of people unemployed).
And while I can still understand the reasoning behind an investment in Tesla, it leaves me rather puzzled how people can invest in some other companies out there. Nikola (NKLA) would be an example. A market capitalization of $23 billion and almost $0 revenue is quite fascinating and cannot really be explained, but Robinhood traders are buying.
While, in the late 1990s, people were buying young companies after the IPO that didn't generate any revenue and had not really a solid business model, people are now obviously also buying bankrupt companies and penny stocks. This seems to be the current characteristic of 2020 - buying penny stocks and bankrupt companies. Hertz Global Holdings (HTZ) is probably the most famous example. On May 22, 2020, Hertz filed for Chapter 11 bankruptcy, and in the next few days, the number of Robinhood accounts that held Hertz almost quadrupled, and we saw a short spike in the stock price, which increased about 600% but already declined about 75% again.
Like it was hard to understand, in the late 1990s, how crappy companies could be worth billions, it is hard to understand today why people are also buying bankrupt companies. Maybe people are operating under the assumption that no company will go bankrupt any more as the Fed is saving every company and will buy up every bond. Although this is not remotely true, it seems to be a popular narrative and a scenario that is often mentioned.
The second lesson is also simple: Analyze the stocks you want to invest in, and don't just invest blindly in any listed company. And as there are different investing strategies, I don't claim it doesn't make sense to buy or trade the above-mentioned assets, but I would question if these assets are suited to be a long-term investment. And while other strategies (like momentum investing) certainly have their legitimacy, you should have a clear exit strategy when investing in these overpriced assets.
Lesson 3: New Era Thinking
Aside from calling valuations into question and assigning ridiculous prices to companies that are either obviously worthless or never deserved such a high valuation, there are many other aspects we can witness. Another classical sign seems to be trashing successful investors that made a lot of money in the past and have proven again and again that their strategies are working. A prominent example seems to be Warren Buffett (for whatever reason). Once again, we have to read countless articles that Buffett has lost his touch - like he allegedly lost his touch in 1999. It is claimed that Buffett doesn't understand investing anymore and that his principles are outdated - although certain investing principles never get outdated (see lessons above and the principle not to invest in companies with a ridiculous valuation - no matter what the business is).
(Source: Annual Report Berkshire Hathaway 2019)
As we see above, Buffett und Munger always had some years where the share price of Berkshire Hathaway (BRK.A) (BRK.B) underperformed the S&P 500 (I marked the years, in which Berkshire underperformed in red) - like in 1999, it underperformed again in 2019. But Buffett und Munger outperformed the S&P 500 in the 10 years leading up to the Dotcom bubble.
And since the beginning of 2000 (the last time when Buffett allegedly had lost his touch), Berkshire Hathaway increased 400%, while the S&P 500 increased only 114%.
It seems almost like a warning indicator for a top and a bubble, when people are claiming that Warren Buffett has lost his touch - whatever that means. As Warren Buffett is usually not participating in the crazy buying in the final stages of a bubble when irrational exuberance kicks in, he almost has to underperform in that year as he is holding a big part of his assets in cash.
Aside from criticizing Buffett, we also see many other aspects in a similar manner as in the late 1990s. According to Shiller, word of mouth is extremely important for a bubble as different ideas need to spread (Shiller is using the epidemic analogy). In the 1990, it was e-mail and chat rooms, which were important contributors to the Dotcom bubble. Today, it might actually be Twitter (TWTR) and Facebook (FB) and many other social media platforms making it even more simple to spread ideas in a quick way from person to person. And just like a virus, an idea can also spread from person to person in an exponential way leading to exponential growth of the people knowing about an idea or thesis (for example, a buying recommendation or bullish thesis about a certain stock).
And when people see stock prices increasing, they must not even hear a bullish thesis about the stock or a buying recommendation. A rising stock market or the rising stock price of a company draws attention, and we enter some kind of feedback loop:
In feedback loop theory, initial price increases […] lead to more price increases as the effects on the initial price increases feed back into yet higher prices through increased investor demand […] Thus, the initial impact of the precipitating factors is amplified, resulting in much larger price increases than the factors themselves would have suggested. (Shiller, p. 84)
A rising stock price is also a kind of confirmation bias as it serves as proof that the bullish opinion must be right. And finally, this leads to FOMO (the fear of missing out), which is hard to fight - even for professional investors. When stock prices climb higher and higher, people feel the urge to participate. I like to mention my article I wrote about Bitcoin (BTC-USD) in January 2018 as I described several aspects in more detail, and the pattern is always the same - it doesn't matter what kind of assets we are talking about.
Lesson: Be aware of confirmation bias, feedback loops as well as the fear of missing out. Like it was dangerous in the past, when emotions take over, it is also dangerous now, and investing without a clear strategy can be dangerous. And don't underestimate Warren Buffett and Charlie Munger as these two have a defined investment strategy.
Lesson 4: Similar Supporting Factors
In his book "Irrational Exuberance", Robert Shiller is naming several aspects that might have contributed to the stock market rally in the late '90s. And while there are definitely some differences between the late '90s and the last few years, there are at least four factors that sound somewhat familiar and might contribute to the rally we are seeing right now.
- Shiller points out that, in the late '90s, it was suddenly much easier to trade (see page 56-58), and the turnover rate on the Nasdaq increased from 88% in 1990 to 221% in 1999 (measuring how many shares of a company were traded in one year compared to the overall number of outstanding shares of any individual company). A few weeks ago, the Nasdaq set a new record with about 6 billion shares traded daily three days in a row. I would also argue that Robinhood and other similar apps are making it very easy to trade and are lowering the barriers to entry once again as apparently kids are also trading now. The fact that you can trade only the fraction of a share is also making it easier for people with only a small budget to gamble in the stock markets.
- A second factor that might have contributed to the stock market rally in the late 1990s, according to Robert Shiller, is tax cuts as well as the anticipation of possible future capital gains tax cuts, which can have a favorable impact on the stock market (see page 45f.). We also saw tax cuts under the Trump administration which led to a rally in the stock market (not necessarily after the tax cut happen, but before, in anticipation as the market is forward-thinking). And even after the tax cut, Trump talked several times about another tax cut, and depending how plausible that scenario was for investors, it could also have had a positive effect on stock prices.
- In the 1990s, the decline of other nations - especially the collapse of the Soviet Union - could also have had a positive effect on the market as the weakening of major rivals has to be seen positive for the United States and the US companies. Shiller is calling this triumphalism in his book (see p. 43). It might be possible that Trump's "Make America Great Again" could have had a similar impact, and many investors believe in the extraordinary strength of the US economy.
- And finally, Shiller argues that increased gambling opportunities contributed to the stock market boom in the 1990s. The rise of gambling institutions had an effect on the culture and the attitude towards risk among the US population (see p. 58f.). While, back then, it was especially the rise of gambling opportunities, I would argue that the lack of gambling opportunities in the last three months contributed to the stock market boom. Due to the lockdown, casinos had to close, but people want to gamble (especially those people that are addicted) and, therefore, had to find alternatives. It seems like many of these people starting trading - and while I strongly oppose calling the stock market a casino, I can see why the stock market is appealing for gamblers.
These are four factors that could have contributed to the stock market rally in the last decade and might have contributed to the euphoria we are seeing in the last two months.
Lesson: Like it contributed to the bubble two decades ago, tax cuts, the closing down of casinos as well as new and easier ways to trade might have contributed to this bubble. This leaves us in a state of high risk for setbacks in the stock market.
Limitations Of The Comparison
I am perfectly aware that the comparison between the long bull run in the 1990s and this cycle has its limitations. In the years leading to the peak in 2020, we also saw signs that we are moving towards a bubble, but we did not see the same level of euphoria as in 2000. After the extreme crash we witnessed in March 2020, it was only about two months of time to build up the euphoria we are seeing right now, and according to Robert Shiller, these narratives and stories usually take a long time to build up and speculative bubbles can go on for quite some time:
[S]peculative bubbles and their associated new era thinking do not end definitively with a sudden, final crash. On reflection, this is not surprising, given that speculative prices are essentially formed in the minds of millions of investors who buy and sell, and it is unlikely that so many people would simultaneously arrive at sudden and enduring changes in their long-run perceptions. (Shiller, p. 143)
So, it would not be surprising for this bubble to go on for several months. But it seems like reality is kicking in again on two fronts: the rapidly rising number of COVID-19 cases in the United States should clearly demonstrate that COVID-19 is far from over (and we are not even talking about a second wave as the first wave never ended in the United States) and the upcoming earnings season will also demonstrate in what shape companies actually are.
When comparing 2020 to 2000, neither valuation levels nor the euphoria seems to be at similar extreme levels right now as back then, which is a good sign. But, while in 2000, the stock market declined primarily as the bubble busted and especially the Nasdaq collapsed, we are not only facing euphoria, FOMO and unrealistic valuations today. Although many people seem to deny this (as part of the euphoria), the economy is facing other very real threats. On the one side, we had several countries all over the world going in different states of lockdown during the last months which led to a severe recession. On the other side, COVID-19 is far from over, and without a vaccine, it seems impossible to estimate for how long the world and the economy will have to adjust to the virus and its deadly consequences, and further lockdowns are possible.
Robert J. Shiller (2015): Irrational Exuberance. Revised and expanded third edition. Princeton University Press.
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