It’s so easy to say that “this time is different”; if there’s one thing that’s never different in stock market tops, it’s that people will never stop saying “this time is different”.
I’ve started collecting old news articles about stock market tops to remind myself of how to stay grounded in my valuations.
Because I’m just as likely to get overly excited about a stock as anyone else.
It’s so easy to fall in love with a stock—its stellar price performance, its darling status among consumers, the business community, or Wall Street, its impossibly impressive track record. The list goes on and on.
There’s nothing wrong with getting excited about a stock, it’s just when that overexcitement leads to you making exceptions to justify higher valuation estimates where you can run into trouble.
And where “this time is different” with the seemingly unlimited potential for a unicorn company can haunt you for years or even decades.
Both of these news articles I will quote are from CNN Money—one was written November 9, 2000 and the other December 29, 2000, just months after the NASDAQ peak in 2000 and a few months before the final peak in the Dow to come.
CNNfn.com asked the market data and research firm Birinyi Associates of Westport, Conn., to calculate the market value of the 280 stocks in the Bloomberg US Internet Index at their respective 52-week highs and their current market value. The combined market values of the 280 stocks had fallen to $1.193 trillion currently from $2.948 trillion at their peak, a loss of $1.755 trillion, most of which occurred between March and September of this year.
Ouch. It gets worse, in continuing to describe the “Internet Index”:
Of the 280 stocks in the index, 79 are down 90 percent or more from their 52-week high. Another 72 are down 80-89 percent. Only five are down less than 5 percent.
The collapse of the Internet bubble, perhaps one of the largest financial fiascoes in U.S. history, came after a three-year period, starting in January 1997, when investors would buy almost anything even vaguely associated with the Internet, regardless of valuation. Investors ignored huge current losses and were willing to pay 100 times expected earnings in fiscal 2002. They were goaded by bullish reports from sell-side securities analysts and market forecasts from IT research firms, such as IDC, Gartner and Forrester Research.
Recapping the turbulent year of 2000, which ended up being just the start of intense pain for investors for YEARS, we saw these developments:
What went wrong? Analysts have several answers. Chief among them: higher interest rates. The Federal Reserve raised rates six times between June 1999 and May 2000, pushing the central bank’s target rate for loans between banks to its highest levels in a decade…
…But interest rates were just part of the story. The price of oil surged this year, climbing above $37 a barrel in September, increasing energy costs for business and consumers…
…This was also a year when staid investments became sexy — and sexy turned staid. Sysco, the food distributor, outperformed Cisco Systems, a kind of proxy for the growth of the Internet…
…In fact, by at least one measure, this wasn’t so bad a year — Standard & Poor’s says that, as of Thursday, 278 of the stocks in the S&P 500 were higher this year while 216 fell. It’s just that the losses in the losing issues far outweighed the gains in the gaining ones.
There’s really two diverging paths there; one that the unrecoverable pain happened in the stocks where this time was supposed to be different, and two that the stocks who recovered enough to sustain decent long term investors were those who tended to not be bid as highly (optimistically) as the others.
To me, companies that are boring are sexy because they usually provide a margin of safety on the price paid.
These will be the last companies that investors will justify as “this time is different”, because their valuations tend to stay in the world of reason, which is a timeless principle.
It’s brutal to be in these kinds of stocks at times, as others might mock you for not being involved in the latest frenzy.
But time and time again, the market eventually changes its mood, and those investors who found themselves in the most expensive stocks lose their shirt.
When I see evidence of a potential stock market top, I realize that this is the time to double down on boring and demand even more of a margin of safety—not the other way around.
The Timing of Stock Market Tops – Isn’t What You Think
Something I found extremely interesting as I examined stock market tops was how the top for the Dow and the top for the NASDAQ in 2000/2001 was as much as 14+ months apart!
Quote (bolded emphasis mine):
The technology-heavy NASDAQ stock market peaked on March 10, 2000, hitting an intra-day high of 5,132.52 and closing at 5,048.62.
The Dow Jones Industrial Average, a price-weighted average (adjusted for splits and dividends) of 30 large companies on the New York Stock Exchange, peaked on January 14, 2000 with an intra-day high of 11,750.28 and a closing price of 11,722.98. In 2001, the DJIA was largely unchanged overall but had reached a secondary peak of 11,337.92 (11,350.05 intra-day) on May 21.Source
In the years to follow these bull market tops, the Dow greatly outperformed the crashing NASDAQ, until the stock market as a whole finally rebounded in 2003.
While the NASDAQ was losing 30%+ per year through 2000 – 2002, the Dow retained annual losses closer to the -10% mark.
The popping of the technology bubble affected all of the stock market, without a doubt; but the relative performance between the two indexes showed a vastly different story for each.
In other words, while investors might fear big market crashes which tend to follow stock market tops, the actual results for an investor could be more dependent on the types of stocks in a portfolio rather than just the fact that the investor is long the market.
I found some interesting parallels to the 2021 stock market of today with the choppy stock market top of 2000, and I think they’re worth examining.
For one, though the NASDAQ started coming unloose in 2000, the economy in the years prior was not showing signs of struggle, yet.
In fact, the time period preceding these events saw a very accomodicative policy by the Fed, in the form of falling interest rates.
Interest rates had a big impact on 2000 and continue to impact stocks today.
The Effect of Interest Rates on an Economy
Not only do interest rates affect the valuation of assets like stocks and bonds—as investors weigh investment alternatives, opportunity costs, and risk appetites—but they also play a big role on the natural boom and bust cycle of the economy.
Falling interest rates stimulate the economy in many ways.
And this stimulus effect has a strong rippling effect throughout the economy, which builds on itself to drive much activity forward.
One easy example to understand the impact of low interest rates are new businesses. When a new business needs to find additional capital in order to expand, it might look to a bank for a loan.
When interest rates are lower, the interest rate expense will be cheaper, which could allow a business to afford a higher loan. With that higher loan is likely to come increased expansion, when generates more revenues that pass down through the economy.
The economy is really like an economic machine which drives activity, revenues, and investment higher (or spirals lower) as the economy expands and contracts.
One adverse effect to an expanding economy is inflation.
Inflation, or rising prices, happens because so much money is flowing through the economy through added investment from lower interest rates that prices inevitably follow higher.
In the continuous chase for growth, companies weigh supply and demand in order to set their prices, and raise them when enough demand can support them.
With more money in consumers hands (through higher wages/ more jobs), there becomes more money chasing goods and services. That’s classic higher demand.
Prices follow that higher demand upwards, causing inflation.
When inflation gets too out of control, you inevitably get people who are left behind. As an economy is expanding, the people and businesses taking risk (investing to grow their business, etc) get rewarded as they earn high returns on their investments as the economy absorbs their expansion.
But, in an expanding economy, the people taking more risk get more of the reward, as the expanding nature of the economy supports higher growth rates and allows more leveraging to be done.
More business deals, more investments, more taking on of expenses… the list goes on and on.
The Cons of Economic Expansion From Low Interest Rates
At a certain point though, too much expansion led by risky behavior pushes inflation higher, and in effect punishes more conservative individuals and businesses.
If this goes on for too long, those at the bottom of society start to struggle—which causes great inequality and unrest. Those whose wages don’t keep up with an expanding economy while struggle more to survive as inflation races higher, those not working (such as retirees) will struggle to pay expenses on their low returning investments, and the list goes on.
The bottom line is that an ever-expanding economy with uncontrolled inflation can cripple a society just as much as it can enrich one, which is why inflation needs to be checked in a healthy economy.
So, to counter the negative effects of inflation, an institution like the Fed will allow interest rates to rise, which contracts the economy and tames the inflation from an economic expansion.
Rising interest rates affect the economy in all of the opposite ways that falling rates did.
Businesses take out less or lower loans, invest less in expansion; they might hire less, and unemployment might rise.
The worst risk-takers from the economic expansion might get wiped out, which causes more unemployment and losses for institutions like banks who made the loans, or landlords which depend on the rent from their business tenants.
This obviously plays out into the stock market, which doesn’t like to see contracting profits and will sell off some of the worst offenders.
More Events Which Defined the Stock Market Top of 2000
That brings us back to the example from 2000, and explains why the rising interest rates predictably affected the stock market for several years. Going back to CNN Money (their end of year 2001 article), they had this explanation on the falling market:
The stock market’s bust requires a look back at its boom. The rise of the Internet drew an unprecedented amount of money into fast-growing technology companies, some of which never showed a profit. Businesses, meanwhile, poured millions of dollars into computing systems, storage and communications networks. Demand for new workers pushed the unemployment rate to a 30-year low of 3.9 percent last year.
As the cycle peaked, businesses cut spending and orders for manufactured goods fell. Economies in Asia and Europe weakened. A strong dollar made it tough to sell goods abroad. Some say the Federal Reserve hiked interest rates too much last year. Others say central bankers didn’t cut rates soon enough.
The price of oil saw a substantial price rise during the 2000-2002 period, as did many commodities. Real estate and bonds became the assets to own. Stalwarts like Microsoft saw price recoveries, while others like Amazon fell as much as 70%+.
Interest rates rose, internet stocks got wiped out, and boring stocks outperformed the bull market’s darlings.
Of course, the stock market eventually recovered from the dot com crash, but it took the S&P 500 around 7 years to pass that previous peak, only to fall into another tough bear market (’08-’09).
Investing at this stock market top was brutal for many.
As interest rates fell to rock-bottom lows in 2020 as a result of the worldwide pandemic, the stock market saw its own period of boom for the year.
What will be interesting to watch is whether all of the stimulus combined with the low interest rates will lead to inflation, which will compel the Fed let rates rise (To learn more about the Fed’s role in controlling interest rates, be sure to check out Dave’s excellent article on the functions of the Fed).
While inflation in an economy is tough to quantify and does not come with a perfect measurement, there are some interesting trends which we’ve seen already through the first months of 2021:
- Rising commodity prices like oil and lumber
- Extremely fast growing residential real estate prices
- Unprecedented high asset prices in stocks and bonds
- Even more extreme price appreciation in alternative assets
- Art pieces
- Particular Nike shoes
- Other cryptos
I might feel like we are close to a stock market top, but that doesn’t make it true.
Whether you are reading this now or someday distant in the future, keep that in mind as you try to draw parallels between market conditions now against past stock market tops.
I don’t know of many people who got rich when timing the market.
History doesn’t show much evidence of that either.