This work was inspired by UCLA Professor Michael Brennan’s efficient autopsy of the dot.com bubble.  Published in 2004, the piece broke down the mania that led to the historic bubble in 2000.  A misplaced belief in Efficient Markets, agency problems on Wall Street, and weak accounting rules figured large in his work.

This paper will do the following:

  • Update the simple yet powerful evidence he provided that equities had been in a bubble
  • Provide compelling evidence that the problems that drove the mania in 1999 are present again today
  • Offer a list of stocks where today’s accounting rules are most severely misrepresenting economic reality

Asset Allocation Gone Wrong: The Cult of Equity

The most basic evidence can often also be the most compelling.  In his first sentence, Dr. Brennan explains that price appreciation outstripped earnings growth by a huge margin between 1980 and the peak of the dot.com bubble.[1]  Figure 1 below shows this effect in raw form.

The navy blue line is the total return of the S&P 500 between 1980 and August of 2000.  The light blue line is the growth in those stocks’ earnings.  Stocks rose 2,526% while earnings only grew 327%.

Rarely have we seen a more compelling image of a bubble.  With hindsight, the evolution of price and earnings made it painfully clear.  Capital markets and fundamental valuations had totally detached.

The United States Financial System Decouples from Reality

YOU ARE NOW READING BASIC MEMBER LEVEL CONTENT

Think that’s crazy?  Look at the next chart…

Democratizing Investing Gone Wrong

The chart below merely updates the one above. Just another way of visualizing extreme overvaluation.   Warren Buffett’s valuation metric and its long term predictive accuracy all indicate many investors may not understand the risks they are taking

KCR’s research team finds itself writing the phrase “this isn’t complicated” a lot lately.  Look at our chart about zombie firms[2] that can’t pay their interest expense.  The value of stocks priced for disaster.  Or our research on the soaring exposure of index investors to loss-making firms.

These charts conspire to tell one simple story: don’t buy stocks that fail the basics of common sense.

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[1] Brennan, Michael John, How Did it Happen? page 1

[2] We chose to link to Lance Robert’s terrific piece “Could the Fed Trigger the Next Financial Crisis?” as he uses our chart on the market cap of stocks that can’t make their interest payments from earnings despite record low rates and, in that piece, speaks more comprehensively to the issue of Zombie Firms.  For those that don’t follow Lance’s work on Real Investment Advice we cannot recommend it more highly.   Neither KCR or its affiliates has any commercial relationship with Lance or Real Investment Advice.

[3] Warren Buffett, Letter to Shareholders, 2020, Page 12

[4] We understand this may seem hyperbolic.  But when you have to choose between making a lot of money or being sacked at what is often the low-point of your track-record and career, this stuff creates existential stress in our view.

[5] Brennan, Michael John, How Did it Happen? page 9 and page 2, respectively

[6] To see KCR’s Custom Index of “Enron Look-Alike Stocks” today click on our post offering a free hat to our subscribers – originally written in jest we have been stunned as some of the most accomplished and experienced Fund Managers in the industry have taken us up on the offer.  We would like to thank them for sharing our appreciation for the need to keep financial history’s darkest moments close!

[7] Brennan, Michael John, How Did it Happen? page 9

Disclaimer

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