After years of big stock market gains, especially by giant tech companies, it’s no wonder many investors fear a replay of the tech-induced market crash of 2000.
Maybe, though, we’re fretting over nothing. Despite isolated cases of irrational exuberance – yes, that’s you we’re talking about, Tesla Inc. – share prices, even in the tech sector, are still largely in touch with reality, according to a pair of reports last week.
To be sure, the upbeat analysis in these reports rests on the assumption that interest rates aren’t going up any time soon. But if you accept the notion that today’s low rates are likely to persist, current share prices look only elevated, not outrageous.
In fact, U.S. stocks would have to rocket 28 per cent from where they stand now to match the head-spinning valuations they reached during the dot-com madness of 1999 and 2000, according to John Lonski, chief economist at Moody’s Capital Markets Research.
In his weekly report, he looked at how expensive stocks are in relation to “core after-tax corporate profits” – a measure of profitability that tries to isolate companies’ sustainable earnings by excluding one-time gains or losses.
Mr. Lonski calculated that stocks traded for 22.5 times core after-tax corporate profits in September, 2000, when dot-com fever was near its peak. By comparison, stocks now change hands for only 17.5 times those underlying profits – a much more reasonable valuation.
Today’s stocks are not only considerably cheaper than their dot-com ancestors, they are also far more enticing in comparison with alternative investments such as bonds. Back in 2000, investment grade corporate bonds yielded more than 8.3 per cent. Today, they pay out only 3.9 per cent.
In practical terms, that means a dot-com-era investor had a tempting place to put her money if she didn’t want to venture into the stock market back in 1999. Today’s investors aren’t so fortunate because the payouts from current bonds are nowhere near so attractive. This lack of alternatives means investors in search of a decent payoff have no choice but to wander into the stock market.
The catch is that low rates, by themselves, don’t guarantee big gains ahead for shareholders. While stocks are far less expensive than they were during the dot-com era, they are still pricier than they have been for most of the past three decades.
So what to do? In a report last week, Goldman Sachs strategist Ryan Hammond suggested investors should stick to what has worked so well in recent years – technology stocks. “The 48-per-cent rally in info tech stocks during the past 12 months has been the strongest among S&P 500 sectors but still pales in comparison to the tech bubble,” he wrote.
During the heady stretch from 1995 to 2000, info tech stocks returned 700 per cent, he said. By comparison, they have returned only 149 per cent during the past five years. Instead of being propelled by unrealistic expectations, as they were in the 1990s, they are now firmly supported by faster sales and earnings growth, as well as higher margins, than the S&P 500 as a whole.
This is true not just for a handful of tech giants, but for a wide swath of companies in the sector. Among the stocks that Mr. Hammond finds attractive are big names such as Microsoft Corp., Mastercard Inc. and Qualcomm Inc., as well as less heralded companies such as Dropbox Inc., Paychex Inc. and Monolithic Power Systems Inc.
All these businesses boast high and stable sales growth, strong returns on equity and reasonable valuations. Mr. Hammond suggests that investors who want to navigate this pricey stock market may want to consider building a portfolio of these and similar companies.