The dot-com crash of 2000 doesn’t offer a useful comparison with today’s predicament, our columnist writes.
Photo: Chris Hondros/Getty Images
Stocks are at their most expensive since the dot-com crash two decades ago, according to Wall Street’s standard valuation metric. But the forward price-to-earnings ratio is broken, and alternatives show the market is cheaper, even if it’s still no bargain.
The advantage of the PE ratio is it measures the two things investors really care about: the price of a share in a company and the earnings that share will produce in the near future. A high PE ratio suggests shareholders are optimistic that earnings will grow a lot beyond the forecast period while a low PE ratio shows earnings growth is expected to be weak.
The disadvantage is becoming painfully obvious. The PE ratio uses what Wall Street analysts think companies will earn over the next year as a proxy for long-run earnings. It assumes the distant future will look something like the near future. Right now, that assumption is badly wrong: Lots of companies are in survival mode this year but should return to health next year or the year after.
Ignoring concern about today’s superhigh multiple of just under 21 times the next 12 months’ earnings amounts to saying “it’s different this time”—a dangerous dismissal that echoes the same claim in the go-go years of the late 1990s. Wall Street bulls back then rejected traditional valuation tools as irrelevant in the new online economy, and switched to bizarro methods such as price-to-click ratios for fashionable but lossmaking startups.
Yet, it probably is different this time. I say probably, because we might end up in a new Great Depression, in which case stocks are indeed ludicrously expensive. Barring that extremely nasty outcome, this year’s earnings just won’t be a good guide to the future.
This is the problem that usually applies to trailing PE multiples. The ratio of price to the past 12 months of earnings reaches its highest once the bad news is in the rearview mirror, because past earnings were awful, while stocks are already rising in anticipation of better earnings in future.
What we really want is to look further ahead, estimate earnings and their growth rate after the crisis abates and discount it back to today to come up with a valuation.
The simplest approach is to assume that in the best-case scenario, earnings recover to the same level as 2019. On this basis, the S&P 500 is nothing like as expensive as in the dot-com bubble, at 18.7 times operating earnings as measured by S&P Dow Jones Indices (operating earnings aim to measure the steady-state performance of a business, and while far from perfect, are the norm for PE ratios).
The index isn’t in any sense a bargain, either. I would want a bigger discount to cover the time needed to recover and the risks of the recovery going wrong.
A more sophisticated approach is to use a longer period to try to factor in steady earnings over an economic cycle, something Yale Prof. Robert Shiller does with his cyclically adjusted PE ratio. This compares stock prices with the past decade of inflation-adjusted earnings, assuming that companies will in the future be roughly as profitable as in the past over long periods.
The Shiller PE has fallen to a more reasonable level, back down to where it stood in 2016. Prof. Shiller prefers to look back much further, and on this basis stocks are still more expensive than at any time from the 1929 crash up to 1986. If companies grow faster with higher profit margins, and inflation and interest rates stay low thanks to globalization and the rise of disruptive technology, higher valuations make sense. If we’re entering an era of trade wars and tougher antitrust enforcement, those profit margins look exposed.
Looked at properly, valuations tell us what we already know from the price moves. Investors are optimistic about the prospects of many big growth stocks, such as Microsoft and Amazon. They think pharmaceutical companies will do well, and have hopes for enough others to rebound to set up a decent recovery in earnings. But there’s realism about the grim prospects for some stocks, such as airlines, which haven’t bounced back with the wider market.
Investors would be wrong if the economy sinks into depression, or if the politics of lockdown means significantly slower growth or higher inflation and interest rates in future. Equally, the market isn’t prepared for a rapid return to normal, which would lift stocks that have been struggling, and mark out airlines as a historic buying opportunity.
My advice is to forget comparisons with the dot-com bubble. Valuation tools are only as smart as their users.
A down day at the New York Stock Exchange in January 2000.
Photo: Chris Hondros/Getty ImagesWrite to James Mackintosh at James.Mackintosh@wsj.com
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