Bubble Trouble? – Comparing the Current Markets to 1999 and 2007

• Introduction
• Quantification of Overall SMID and Large Cap Market Metrics
• Summary Charts
• Conclusion: The Sun Micro Sanity Check
• Appendix

Introduction

Many clients have asked us for our perspective on how the markets look now compared to previous periods. Specifically, there has been much discussion among prominent investors about whether the market is in a “bubble” now, much like the Technology Stock Bubble in 1999-2000 and the markets during 2007 when the debt and housing bubble spilled over into equities in the form of elevated profits.

Our goal in this paper is to look at current markets compared to history with a specific focus on two recent pre-crash periods: 1) the 1999-2000 Tech Bubble and 2) 2007.

In Robert Shiller’s Nobel Prize Lecture on Speculative Asset Prices, Shiller gives his definition of a bubble as follows:

A situation in which news of price increases spurs investor enthusiasm which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increase and bringing in a larger and larger class of investors, who, despite doubts about the real value of the investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.

My definition puts the epidemic nature, the emotions of investors, and the nature of the news and information media, at center of the definition of the bubble. Bubbles are not, in my mind, about craziness of investors. They are rather about how investors are buffeted en masse from one superficially plausible theory about conventional valuation to another.¹

With growing number of small stocks and firms whose valuations seem to levitate despite a dearth of profits and IPO market whose median Price/Sales ratio has eclipsed 14x, the highest level since the dot com bubble, it is no wonder the term “bubble” has once again entered the investing lexicon.²

While we find the discussion of bubbles interesting we will avoid making any claims pertaining to timing and instead just focus on the facts using simple measures of valuation, profitability and firm health as defined by leverage. In the companion paper also published today, we will pay particular attention to the dispersion of valuation and other metrics between the most expensive and cheapest deciles of stocks relative to their own histories. Please see Comparing the Small & Mid Cap Valuation Tails: Low Dispersion, Reduced Opportunities & Fundamental Fixes for analysis around the least and most expensive parts of the market. Many investors feel that large dispersions are what create the most opportunities for outperformance, and we agree. Some investors seem to feel that we are in a bubble now and that this implies significant dispersion and therefore opportunities. Unfortunately, as we show in the other companion paper, while markets certainly are expensive, we do not see the typical dispersion and investment opportunities that can sometimes accompany a bubble. We are hardly in the territory of the Sun Microsystems stock epidemic that plagued markets in 2000. This lack of dispersion despite the most expensive decile being very expensive is because all deciles within the markets—including the cheapest decile—are also very expensive relative to their histories.

To summarize, our conclusions are as follows:

1) Valuations in the Small & Mid Cap space are at record highs despite ROEs which have been on a declining trend for the last three decades.

2) Large Cap valuations have eclipsed levels seen in 2007 on the back of soaring EBITDA margins, but valuations are below levels observed during the Tech Bubble in 1999-2000.

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