Charles Mackay, author of Extraordinary Popular Delusions and the Madness of Crowds, wrote that “men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one.”
This is as concise a description of an investment bubble – and its subsequent popping – as you are likely to find. Greed for personal gain, and perhaps envy over your (less talented, less good looking) neighbour’s financial success, are the seeds of a bubble: thinking in herds. Panic and fear, that you might be the last bagholder, mark the bubble’s popping: recovering slowly and one by one.
Mackay wrote those words in 1841 and yet, over 180 years later, it is evident that we as a species have learnt nothing from his warnings. Across geographies and asset classes, there have been numerous examples of bubbles over the past century. In the US alone, and in just my lifetime, there has been a bubble in equities (2000) and housing (2006). More recently, there has been a bubble in technology stocks (particularly unprofitable ones) and cryptocurrencies.
A curious feature of bubbles is that a small basket of stocks often gets lionised as the companies of the future and get bid to very high levels. This happened in the “Nifty Fifty” bubble of 1973-75, when the top five stocks came to represent 23.1% of the S&P 500 Index. (The Nifty Fifty bubble was a group of fifty-or-so US blue-chip stocks which came to be regarded as buy-and-hold growth stocks whose fundamentals were so strong that they could be bought at any price). It happened again in the dotcom bubble of 1999-2000 when the top five stocks represented 18% of the S&P 500, and again in 2020-21 when the top five stocks represented 23% of the S&P 500. The latest bubble is being dubbed the e-commerce bubble and was focused on technology stocks (particularly unprofitable ones), “meme” stocks, and cryptocurrencies.
Very often, these companies are indeed gamechangers, and their status as darlings of the market is usually well earned. Consider, for example, the e-commerce bubble. At the peak, the largest five constituents were Microsoft, Amazon, Apple, Alphabet, and Tesla – one would find it hard to argue that these five companies were not major revolutionaries in their fields. Looking at the other times when a few stocks came to dominate the index, we would also find names that were revolutionary at the time (although the names might be less familiar).
If the market correctly evaluated these stocks as good businesses, are there any lessons then to be drawn from these extremes?
The lesson is not that the market was wrong about these stocks being great businesses. It was wrong about the valuation it placed on these companies – which is how they came to be such a large part of the S&P 500 in the first place.
We wrote a Did You Know? segment in November 2021 which showed that bubbles are dangerous because they reduce future returns for investors. This general lesson about asset pricing is also applicable to individual stocks.
The three tables below show the outcome of paying a high price for these businesses.
The first table shows the four largest stocks in the S&P 500 during the Nifty Fifty Bubble: Avon, Xerox, Polaroid, Eastman Kodak. In the cases of Avon and Xerox in particular, the market got completely carried away, paying 63 and 254 times earnings respectively for these companies! The subsequent returns over both 5- and 10-year periods were deeply negative, reflecting the de-rating of these stocks when their growth prospects failed to materialise.
A similar story was witnessed during the dotcom bubble. The top four stocks in the S&P 500 at that time were Cisco, Intel, Microsoft, and Oracle. Similar to the Nifty Fifty period, valuations here became untethered from fundamentals, with investors willing to pay (at the low end!) 50 times earnings for Intel and 230 times for Cisco. This was a truly epic bubble. The subsequent returns over both 5- and 10-year periods were again deeply negative. An investor who invested in any of these stocks at such valuations would have to wait many years before making their money back – if they made it back at all.What fate might lie in store for the darlings of this latest market cycle? The table below shows that the top five stocks in the S&P 500 had high valuations (similar to the Nifty Fifty – perhaps not as wild as the dotcom bubble) and have already undergone a sizable correction.
However, history suggests that the 5- and 10-year returns from here may not be good. A lot will hinge on whether these stocks’ future earnings growth increases in line with, or above, expectations. In the event that earnings disappoint, investors have in the past shown themselves more than capable of significantly de-rating a stock!
And while history is only a guide – not a crystal ball – the lessons from the Nifty Fifty and dotcom bubbles are that high price-to-earnings ratios can be sustained if well-above-average earnings growth can be sustained. The reality, however, is that rapid earnings growth is rarely sustained and when growth normalises the dangers to high starting price-to-earnings ratios are significant. As the old saying goes, the higher they fly, the harder they fall!
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