Are stock markets heading for another dotcom-style bust?

The frenzied and downright bizarre trading in GameStop and silver in recent days has reminded some veteran market watchers of the conditions in the run-up to the bursting of the dotcom stock market bubble at the turn of the millennium.

That period also saw wild leaps in valuations of companies with very uncertain prospects.

The US stock market peaked in March 2000 – and fell by 50 per cent over the next two years.

The Nasdaq Composite Index, which is made up of technology firms, slid by nearly 80 per cent.

Amir Sufi, an economist at the University of Chicago, estimates that some $6 trillion (£4.4tn) in American household wealth was destroyed in the bust.

Now people look in wonder at how companies such as Pets.com were ever valued so highly.

So could we be about to see a repeat of history? Could we see another mighty stock market collapse?

There’s certainly been an influx of amateur investors and speculators into stock markets over the past year, similar to the pattern two decades ago, when many were lured in by the promise of quick riches and a fear of missing out.  

“I dumped my savings into GME [GameStop], paid my rent for this month with my credit card, and dumped my rent money into more GME,” one Reddit user boasted last week.

But the important question for most of us is not whether certain stocks have become disconnected from reality, but whether the wider stock market, in which our pensions are invested, is overvalued?

Speculators bet against GameStop on a vast scale, with a short interest of more than 100 per cent of the company’s equity last month.

But another favourite of short sellers in recent years has been Elon Musk’s electric car company, Tesla, which in December reached a stock market valuation higher than the combined market capitalisation of all the nine largest global car firms, despite manufacturing only a hundredth of their vehicles in 2019.

The dollar losses of the short sellers on Tesla have been many multiples of the GameStop losses.

So is GameStop a microcosm of the broader market? An indication that something more fundamental if out of kilter with reality?

One popular measure of the overvaluation of markets is the “cyclically-adjusted price earnings ratio” or CAPE, developed by the Nobel laureate economist Robert Shiller.

A price earnings (PE) ratio compares the value of a share index to the value of the earnings (profits) of its constituent companies.

The theory is that the more stretched the PE ratio the more (potentially) overvalued the stocks are, because collective share prices should be tethered to collective profits.

The earnings in the PE ratio are also “cyclically adjusted” to iron out the impact of recessions on corporate profits.

The CAPE last month had a value of 34. That’s higher than before the 2008 financial crisis (28), higher than before the 1929 Wall Street Crash (33) and only surpassed by the value of 44 hit just before the dotcom bubble.

Some have taken that reading as an indication that we are indeed in a stock market bubble, perhaps inflated by record low interest rates and central banks’ money printing.

Those who hold this view think that this monetary easing has pushed cash into the public’s pockets and encouraged speculation in stocks.

It’s certainly striking that the US stock market has soared since March while the American and global economy has been plunged into the biggest economic slump since the 1930s.

In March, US stocks fell at a faster rate than during the Wall Street Crash of 1929. The market’s turnaround came after the US central bank, the Federal Reserve, said it would engage in effectively unlimited money printing to combat the economic crisis.

The argument is that this money printing has disconnected markets from fundamentals and that a major correction is due.

“I believe this event will be recorded as one of the great bubbles of financial history, right along with the South Sea bubble, 1929, and 2000,” says Jeremy Grantham of the asset manager GMO.

But this is by no means a universal view among analysts.

Some note that the big gains in US stock markets over the past year have been driven mainly by large multinational technology firms, which are the sort of companies who one might well expect to benefit in the long term from a pandemic that forces billions of people to stay at home and use their computers.  

Facebook, Amazon, Apple, Netflix, Google and Microsoft currently make up a quarter of the value of the S&P 500, up from 7 per cent a decade ago.

So, if you buy into the argument that these global technology behemoths are fairly valued, one might argue that the overall rally is not disconnected from economic fundamentals.

Simon Jones of Capital Economics calculates that although the valuation premium of large tech firms is quite large relative to the rest of the market (measured by the price earnings ratio), it is not as large as that of the information technology sector relative to other stocks during the dotcom boom.  

“This is one reason why we remain wary of the idea that big tech firms’ share prices will soon collapse under their own weight,” he says.

So where does that leave us?

The unpalatable truth is that it is very hard – if not impossible – to be confident about whether the market is overvalued or not.  

Stock markets are supposed to reflect investors’ expectations of companies’ future earnings and it is very difficult to know, ex ante, whether or not those expectations are warranted.  

Take Tesla. Will Elon Musk’s firm dominate the global electric car market this century? There are reasons to believe it might, given impending bans on fossil fuel powered cars by governments and Tesla’s head start on developing the technology. But it’s also perfectly possible another manufacturer could end up leapfrogging it.

Irrational frenzies, such as with GameStop, might be circumstantial evidence of a general bubble, but they are not conclusive.

As for the statistical warning signals, Laith Khalaf of the stockbroker AJ Bell notes that value investors have “cried wolf” on the CAPE indicator before, noting that the US stock market index has grown by a quarter since it last hit a peak in early 2018, prompting an earlier round of anxiety about stock overvaluations.

It may be, he suggests, that the CAPE is less useful than it was in the past given the market power and extreme growth potential of big global technology firms.

Perhaps. But as Khalaf, cautiously, says: “The moral of the boy who cried wolf is that the wolf does eventually show up.”