The equity markets are off to a hot start in 2021. The higher they climb, the more articles that I see comparing the current environment to the 1999 / 2000-time frame. One of the benefits of getting older (and trust me, there are not many benefits) is experience. I was a young mutual fund manager back in 1999, I remember that time very well, and would agree that there were some similarities between now and then. But to borrow a phrase from 1999, “it is different this time”.
In 1999, the big concern was the “Y2K Bug,” or the ability for existing computers to realize that 1/1/00 meant January 1, 2000, not January 1, 1900. The fears ranged from wildly incorrect mortgage calculations and power outages, to the more outrageous worries of prison doors opening and airplanes falling out of the sky. 1/1/00 came, and nothing happened. One thing that did happen, however, was almost every corporation updated their computers around the same time. So, we compressed 3 to 4 years of corporate tech spending into 9 months.
This artificial demand led to very strong corporate earnings in the technology sector at the same time the rest of the economy was cooling off due to the Federal Reserve raising interest rates. led to the belief growth in the technology sector had “decoupled” from the rest of the market, and this is where we insert the phrase “it’s different this time”. The increasing acceptance of this new thing called the internet was going to fuel above average earnings growth for years to come, and we have to value these tech stocks differently. And we did! Every time an analyst came up with a new way to rationalize higher and higher stock prices, this was the phrase that was heard, “It’s different this time”.
Prices kept going up, to the point that at the close of 1999, the tech heavy NASDAQ market traded to a price earnings ratio of just over 200. The long-term average P/E for the NASDAQ was around 24. But remember, it’s different this time, until…
First Quarter Earnings in April of 2000
This is when we realized that it may not be so different after all. Once everyone had updated their computer equipment, no one needed anything in the first 3 months of 2000, or for the next few years for that matter. Overly optimistic earnings estimates coupled with excessive growth projections met with reality, and the tech bubble burst in April of 2000 when technology companies announced miserable earnings results and significantly cut their full year guidance. After reaching a high of 5,132 in March of 2000, the NASDAQ traded sharply lower. The NASDAQ did not see a new all-time high until the summer of 2015.
So, how does this time compare to today? Two words, artificial demand. One difference is that we are not limited to a single sector today, but the entire market is feeling the effect of this artificial demand. The Oakworth Investment Committee has talked for some time about the two-headed monster of 1) the pent-up demand from the consumer and 2) the massive stimulus provided by the government. This will produce some fireworks in the form of economic growth as we work through the consumers’ pent-up demand and the sugar high of government spending. The other aspect from 1999 is similar to today is the concern over inflation. With the market and economic reaction from 2000 – 2003, inflation fears did not materialize. We will have to wait and see what happens this time around with inflation.
This is where we start to differ from the 1999 market. First, and most importantly, the earnings expectations for 2021 are deflated, not inflated like they were at the end of 1999. The lack of visibility as we started the global pandemic last year caused most companies to pull their long-term guidance. This left the analysts that cover the stocks to make up estimates on their own, and as you would expect, were very conservative with their estimates. As we go through 1st quarter earnings for 2021, actual earnings are almost 25% ahead of estimated, and full year earnings expectations are surging higher.
I mentioned earlier how the NASDAQ traded at 200 times its 1999 earnings estimate (with inflated estimates). By comparison, today, the NASDAQ is trading at 39 times, while the S&P 500 is trading with a P/E ratio of 22.8. A bit higher that historical normal levels, but nothing like extreme valuations of 1999. Another interesting fact about 1999 was how narrow the rally in stocks were. The S&P 500 ended 1999 with a return of 21.1%. Given that strong performance, it is hard to believe that almost 60% of the stocks in the S&P 500 finished with a negative return for the year. The top 10 contributors in 1999 accounted for a shocking 64.3% of returns for the index, while that same number for the past 12 months was 33.3%.
Comparing the top contributors to S&P earnings from 1999 to the past 12 months also shows a very different valuation picture:
Microsoft is the only stock that made it on to both lists, but the valuation between 1999 and today is dramatic.
This is not to say that investors can’t make the same mistake again. If investors start to believe that the massive stimulus spending and the strong consumer will lead to above average economic growth (GDP) for several years, and place a much higher P/E multiple on equities from current levels, there WILL be some added risk for stock prices. If that were to happen, however, the stock market will need to hit much higher levels than where they are currently.
The coming headwinds of higher taxes (in several different forms), additional regulations from the new administration, and Federal Reserve beginning to taper their bond purchases and hinting at raising interest rates at the same time the sugar high from government stimulus and the consumer spending spree could make late 2022 and 2023 a difficult time for average returns. But for now, we have a few strong quarters of earnings and economic growth ahead of us, so we will cross that bridge when we come to it.