Despite the covid crisis, the stock market is again trading near all-time highs, especially the tech stocks. Valuations are rich, in particular for the NASDAQ which is trading at a price-multiple earnings of 40.
When valuations reach levels which are elevated by historic standards, investors get concerned about whether the market is in a “bubble” that is about to explode. This concern is currently magnified by the fact that the world is currently faced with major challenges.
There is no scientific definition of a financial bubble but in practice it occurs when asset prices reach extreme valuations that are completely disconnected from their true values. Two of the most famous bubbles are the Japanese stock market of the late 1980s and the “internet bubble”. When bubbles explode, prices usually drop by 80% or more.
This time is different
“This time is different” is known to be one of the most dangerous financial statements. History often repeats itself, particularly in financial markets that are often characterized by cycles. Big market upsides are often followed by big market downsides
Nevertheless, something critical is really different this time: interest rates. Interest rates are now near zero or even negative in all western countries including the US. This is something unprecedented as visible in the graph of interest rates going back to 1880 below.
Interest rates are essential
It is not possible to overstate the significance of interest rates near zero. The attractiveness of an investment is always a relative to the risk-free interest rates on government bonds. US Treasuries lie at the basis of the pyramid. If it is possible to earn 5% on a 10 year Treasury with no risk of default why would someone buy an investment that yields 4%? This was the situation for much of the past decades until the financial crisis of 2008 and the assumption that the normal interest rate is around 3-5% is still in the mind of many investors.
However, with interest rates of 0%, an investment yielding even 2-3% can suddenly become potentially interesting for an investor looking to earn at least something and protect his capital against erosion by inflation. 2% corresponds to an earnings multiple of 50x for the stock market, 3% corresponds to 30x.
Looking at this new paradigm it is clear that the market has the potential to reach valuation levels much higher than in the past.
A key aspect of the current market situation is also the quality of the companies. Apple, Google, Facebook and Netflix are all very well-managed, highly profitable firms with extremely strong market positions and near-monopolies.
On the other side, previous bubbles were largely driven by very poor companies. In the tech bubble of early 2000 many companies were loss-making with no competitive advantage and no potential to ever generate profits. The Japanese bubble included many companies trading close to 100 times earnings many of which were fraud. The buying was purely driven by the “greater fool theory” of investors trying to ride the bubble and exit it on time.
The tech sector is richly valued. This limits its short-term upside potential and implies that the current correction could well continue. In particular for stocks like Tesla which have clearly become disconnected from fundamentals. However a general collapse of the tech sector is unlikely.
Traditional companies outside the tech sector have not yet fully recovered as worries about the covid and the economy continue to weigh down on them. This is likely to change once an exit from the covid crisis becomes clearer towards the end of 2020 or the beginning of 2021. However, traditional companies as well as other assets such as real estate should also continue to be supported by the low interest rates. They are likely to be with us for a long time and to continue to act as a fuel for strong asset prices.
We wish all Shana tova for a sweet and happy New Year which will hopefully bring more light than the previous one
Orit Raviv Swery Ilan Weil
Founder & CEO Chief Investment Officer