"The dot-com crash of the late 1990s ... The prices of internet-related firms rose sharply, and investors who hadn’t jumped on board the bandwagon were made to feel they were missing out.
Yet a large proportion of these companies hadn’t even made a profit.
In the crash that followed, huge numbers of investors, me included, lost out.
... many investors — professional ones included — fail to learn the lessons that episodes like the dot-com crash can teach us.
... Legendary investor John Templeton famously warned investors that the four most dangerous words were “this time it’s different.”
... I’ll begin by noting that one of my favorite expressions is “What you don’t know about investing is the investment history you don’t know.”
We’ll use our trusty videotape machine and return to the late 1990s to see if we can determine if this time it’s really different or if we have already been there and done that.
The late 1990s, which included what has become known as the “tech bubble” or the “dot-com bubble”, witnessed the Nasdaq Index rise 400 percent between 1995 and its peak in March 2000 only to fall 78 percent from its peak by October 2002, giving up all its gains.
The period was characterised by investors speculating on IPOs and stocks of companies with high price to value metrics (such as book-to-market and price-to-earnings); low, if any, earnings; high investment; and stocks with lots of buzz in the social media because they were “disruptive technologies”.
History repeats, investors don’t learn
The last few years were a virtual repeat of the technology bubble that culminated in the do-com crash.
We have not only seen increased speculation on IPOs but on even more speculative special purpose acquisition companies (SPACs).
The late 90s also witnessed a burst of retail trading through low-cost online brokerages such as E-trade, with their humorous commercials.
Today, even lower cost and more accessible stock trading is available through apps on mobile devices.
And just as in the late 90s, stock market valuations are at, or near, historic highs (with the CAPE 10 approaching peak valuations), and a few mega-cap stocks comprise a large share of the S&P 500 index —as I write this, Apple and Microsoft alone make up more than 11 percent of the S&P 500 Index.
At the end of 1999, the top ten stocks by market cap were Microsoft, GE, Cisco, Exxon, Walmart, Intel, NTT, Lucent, Nokia and BP, several of which certainly qualified as the disruptors of their day.
... (some people) chose stocks based on his theory that companies that develop innovative products — disruptive technologies — can topple market leaders.
To provide insight into what might be in store for investors in today’s largest stocks, let’s take a quick look at how the top ten stocks at the end of 1999 performed over the period 2000-2021.
While the S&P 500 Index returned 7.5 percent per year, only one of the largest stocks (Microsoft, which returned 10.6 percent) outperformed that benchmark.
The other “disrupters” provided the following returns:
Cisco, 2.2 percent
(and a drawdown of 86 percent during the crash);
Intel 3.3, percent;
Walmart, 5.3 percent;
NTT, 1.5 percent; and
Nokia, -6.3 percent.
GE lost 3.8 percent a year,
while Exxon and BP returned 5.1 percent
and 1.1 percent, respectively.
Lucent did so poorly that it was
eventually merged into Alcatel in 2006,
having seen its stock price drop
from $75 at the end of 1999 to under $3
at the time of the merger.
(Data for stock returns are from the
Backtest Portfolio tool at Portfolio Visualizer.)
The lessons history teaches are that the prices you pay matter and that disrupters often get disrupted themselves via the process economists refer to as “creative destruction”.
... At the end of 1994, before the “tech bubble” began to inflate, the relative price-to-book market of large growth (0.40) to large value (0.85) stocks was 2.1, and to small value stocks it was 2.3 (0.40 vs. 0.93).
By the end of the first quarter of 2000, the ratio had increased to 4.9 (0.21 versus 1.02) for large value and 4.7 (0.21 vs. 0.98) for small value.
Similarly, the P/E ratio spreads widened. In 1994, the P/E ratio spread for large growth to large value was 1.5 (15.8 versus 10.3). For large growth to small value, it was 1.35 (15.8 versus 11.7).
By the end of the first quarter of 2000, those spreads had increased to 2.6 (29.7 versus 11.3) for large stocks and 2.6 (29.7 versus 11.6) relative to small value stocks.
Note that while the valuations of the growth stocks that dominate the major market indices increased dramatically, the valuations of value stocks barely budged — growth stocks became much more expensive, but this was not true for value stocks.
The increase in relative valuations is important because the research demonstrates that the size of the spread contains information on future returns.
... The table below makes clear that the future value premium tends to be much higher following periods when the valuation spread is above the median spread — as it was in 2000.
Subsequent 5-year return difference between value and growth
The widening of the relative valuations led to the dramatic outperformance of value stocks over the eight-year period 2000-07.
Over this period the Fama-French large value research index outperformed the Fama-French large growth research index by 7.6 percentage points a year (8.0 vs. 0.4),
and the Fama-French small value research index outperformed the Fama-French small growth index by 14.6 percentage points per year (15.4 vs. 0.8).
Because of recency bias,
investors who ignored the long-term evidence and the widening of the valuation spread missed out on that outperformance.
We see the same widening of the relative valuation spread today.
For example, in their study, Avantis found that over the period 2010-2019, the book-to-market ratio of large growth stocks had increased 113 percent compared to increases of just 32 percent and 4 percent, respectively, for large and small value stocks.
Similar widenings occurred in P/E ratios, as large growth P/Es increased 61 percent compared to a 33 percent increase for large value P/Es and a shrinkage of 1 percent in small value P/Es.
That trend continued in 2020 as growth stocks far outperformed once again.
We finally saw a reversal of the trend in 2021—while the Russell 1000 Growth Index outperformed the Russell 1000 Value Index by a small margin (27.6 percent versus 25.2 percent),
the Russell 2000 Value Index far out performed the Russell 2000 Growth Index (28.3 percent versus just 2.8 percent).
This was the first out performance of value stocks since 2016.
That out performance continued in the early weeks of 2022.
... the evidence demonstrates that the wide spread in valuations today provides information that indicates value stocks should be expected to generate large premiums going forward, larger than the historic value premium—just as they did after the peak in spread in March 2000.
Using Vanguard’s Growth Index Fund (VUG) and Value Index Fund (VTV), we see that at the end of 2021 the P/B ratio was 3.6 (8.9 vs. 2.5)—not quite as wide as the 4.9 spread we saw before the tech bubble burst, but much wider than the 2.1 ratio that existed before that bubble inflated.
The same is true of P/Es, with the year-end ratio being 2.2 (34.1 vs. 15.6), not quite as wide as the 2.6 ratio that existed at the end of March 2000, but much wider than the 1.5 ratio that existed at the end of 1994.
The same widening occurred in the valuation spreads for small stocks.
The bottom line is that we have basically experienced a repeat of the late 1990s, with the valuations of growth stocks dramatically increasing while the valuations of value stocks remain relatively unchanged.
Lessons from the Nifty Fifty
... The term “Nifty Fifty” was an informal designation for a group of roughly 50 large-cap stocks on the New York Stock Exchange in the 1960s and 1970s that were widely regarded as solid buy and hold, profitable, growth stocks — stocks that were considered one-decision stocks that should be bought, but never sold, regardless of how high valuations went.
Berkin and Lakshmanan presented the following chart showing the similarity in performance of the Nifty Fifty and today’s equivalents, the FANMAG (FAANGs are old news) stocks — Facebook, Amazon, Netflix, Microsoft, Apple and Google (now trading as Alphabet).
The chart also includes the tech bubble (proxied by the Nasdaq 100).
The chart shows ten years of returns, with year five set at the peak calendar years of 1972 and 1999.
For FANMAG, year five is 2020.
Cumulative returns relative to S&P 500
What can we learn from the Nifty Fifty?
Berkin and Lakshmanan noted that there was never a fixed set of 50 companies comprising an “official” Nifty Fifty.
In 1998 Jeremy Siegel used 50 stocks identified by Morgan Guaranty Trust to claim that after 25 years their returns justified those valuations.
However, in their 2002 study The Nifty-Fifty Re-Revisited, Jeff Fesenmaier and Gary Smith pointed out that because many of the Nifty Fifty stocks had more reasonable P/E ratios and thus might not be truly representative, they also considered a separate list provided by Kidder Peabody.
They found that stocks on each list somewhat lagged the S&P 500 over the next 29 years; stocks on both lists underperformed more notably; and stocks with the highest P/E ratios had the lowest returns.
Just like the Nifty Fifty, the FANMAG stocks are great companies that are also considered great stocks — just buy and hold them regardless of price.
What can go wrong?
Unfortunately, just as investors in the great companies in the Nifty Fifty learned, there’s always something that can go wrong.
We just don’t know what it will be — competition, regulatory problems, antitrust issues and other possibilities.
What the FANMAG stocks certainly have in common with the Nifty Fifty of yore are high relative valuations.
For example, at the end of 2020, the average P/E for the FANMAG stocks was over 48. Berkin and Lakshmanan noted:
“One issue for stocks with high P/E ratios is that subsequent earnings can’t just be good, they have to continue to be great.
From the peak of the Nifty Fifty, their earnings still tended to surpass those of the S&P 500.
But, they simply weren’t good enough to justify valuations.”
As Berkin and Lakshmanan noted, history provides us with the insight that as a company gets bigger and bigger, growth becomes harder and harder to maintain.
And the historical evidence also demonstrates that those stocks with the highest growth expectations tend to lag over the long run, while value stocks tend to outperform.
This is the basis for the value premium.
Investor takeaways
History teaches us that just as being smart is not a sufficient condition to outperform the market, being a great company is not sufficient to outperform either — a great company isn’t necessarily the same thing as a great stock.
Valuations matter, and they matter a great deal.
Studies such as Value Return Predictability Across Asset Classes and Commonalities in Risk Premia, published in the March 2021 issue of the Review of Finance, have found that returns to value strategies are predictable in the time series by their respective value spreads
— an increase in the value-growth spread predicts an increase in expected value return.
... It is also important to remember that while investor sentiment has driven the valuations of growth stocks to historically high levels, the valuations of value stocks have not changed very much despite the fact that interest rates are at historic lows.
In other words, while “the market” (as represented by the S&P 500 Index) is highly valued, forecasting low future returns, this is not the case for value stocks.
For example, as I write this on January 27, 2022, while the current P/E of Vanguard’s 500 Index Fund (VFINX) is 21.8,
the P/E of Bridgeway’s Omni Small-Cap Value Fund (BOSVX) is just 9.3,
the P/E of Dimensional’s U.S. Small-Cap Value Fund (DFSVX) is just 10.0,
and the P/E of Avantis’ U.S. Small-Cap Value Fund (AVUVX) is just 9.4
The other lesson is that the creative destruction process of capitalism means today’s leaders rarely persist over multiple decades.
So is it different this time?"
Author LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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