With Wall Street hitting new records, led by the so-called Magnificent Seven mega-tech stocks, many observers are wondering whether we’re in danger of repeating the mistakes of the Tech Boom and bust of 1999-2000, otherwise known as the dot-com bubble.
The S&P 500 has risen 40% from late 2022. The market leadership has been concentrated in a narrow pool of 7 mega-tech names, namely, Apple, Microsoft, Nvidia, Alphabet, Amazon, Meta and Tesla (the “Mag 7”). Yet many investors are uneasy about the recent price action of the market leaders which have led this extraordinary rally. A couple of weeks ago, Nvidia’s stock price rose by a quarter of a trillion dollars in one day!
Pockets of the US equity market are indeed reaching overbought territory, particularly those companies seen as being beneficiaries of the boom in Artificial Intelligence, such as Nvidia. However, observers drawing comparisons with the dot-com bubble of 1999 are wrong.
First, it is important to look at the extremely generous liquidity injections that helped spur the dot-com market spike. The US Federal Reserve (Fed) was then easing monetary policy in response to the Asian crisis of 1997-1998. At the same time, European monetary authorities were cutting interest rates in preparation for the introduction of the euro common currency.
By comparison, in 2023, the market has risen while the Fed has conducted its most aggressive tightening campaign in history, raising the federal funds rate by a cumulative 5.25% since March 2022. So, today’s market cycle is not driven by loose monetary policy, in stark contrast to 1999.
Second, today’s equity market rally has been underpinned by robust earnings and record production of free cash flow (cash generated from operations minus capital expenditure). This is particularly the case among the technology platforms, which are showing an extraordinary ability to convert a large part of additional revenues into free cash flow.
Traditional valuation metrics, such as forward price-to-earnings ratios, show that the leading dot-com stocks were more than twice as expensive as today’s Mag 7 stocks. The story is similar for free cash flow yield (the amount of free cash flow generated per share as a percentage of the share price). For the major tech names in the dot-com period, this was less than half that of today’s market leaders.
US large cap equities have transformed over the last two decades from cash-raising to cash-returning securities. Apart from the fall in initial public offerings, there is an increasing trend in share buy-backs. Yves Bonzon, CIO of Julius Baer, says, “The best S&P 500 companies have become cash-returning machines”.
Source: Financial Times
There is little evidence of a bubble in price-to-earnings (PE) ratios. While high growth companies always command high PE ratios, the Mag 7 stocks have exhibited very strong earnings growth that tends to justify their high valuations. In the late 1990s, many companies were valued purely on a multiple of revenue, because they had no earnings.
Furthermore, the latest earnings season points to relatively cautious corporate management behaviour, with a growing emphasis placed on capital deployment efficiency. The Mag 7 companies are extremely cash rich with billions on their balance sheets.
Third, US equities today are nowhere near as expensive relative to bonds as they were before the dot-com bubble burst. The forward-looking US real equity risk premium (the expected excess return that equities provide over bonds after adjusting for inflation) stands close to its long-term median. Looking back at the same measure in 1999, equities were then priced in extremely expensive territory relative to bonds.
Overall, the stock market resilience in the face of normalised interest rates points to the outstanding quality of the current equity market returns. While some short or medium-term consolidation is likely, the secular bull market in equities is expected to continue. In the words of Yves Bonzon, CIO of Julius Baer, and author of the article in the Financial Times from which this QB drew much information, “This is not a remake of 1999”.
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