STEPHEN JEN: No market peak – AI is still at base camp

London — Is the buoyant US equity market nearing the peak reached before the dotcom bubble? Rising market angst might suggest “yes“, but comparing current pricing with the late 1990s indicates that, far from reaching a summit, US equities may only be at base camp.

Since 2011, US stocks have rallied strongly, with the aggregate market rising sevenfold in nominal terms and fivefold in real terms. The tech sector, in particular, has surged — up 16 times in nominal terms and 11 times in real terms. This has led many investors to worry about a possible repeat of the dotcom bubble burst in 2000.

However, while the aggregate US equity market is not cheap today, tech stocks — now accounting for 38% of the S&P 500 — do not appear nearly as overvalued as they were in the late 1990s. This suggests the rally may still have considerable room to run.

The “Magnificent 7” technology companies — Microsoft, Amazon, Apple, Alphabet, Meta, Tesla and Nvidia — have been on a tear since the end of 2022, rallying by about 300%. Consequently, the unweighted average price-to-earnings (PE) ratio of the Mag-7 is about 70 times, and the median PE is 36 times, both above the historical averages for the S&P 500 and Nasdaq.

Still, while these figures may look high, they are nothing compared to the valuations of the top seven tech companies in 2000.

At the peak of the dotcom bubble, the unweighted average PE ratios across the seven biggest tech companies – Microsoft, Amazon, Cisco, Intel, Oracle, AOL and Yahoo! – was 276 times, and the median PE was 120 times.

A point to note: Amazon’s PE is not included in that average because, at the time, the company was reporting annual losses in excess of $1bn, a far cry from how it is performing today.

Another common investor fear is that today’s US equity rally could be more dangerous than during the dotcom era because the market has become so concentrated.

At first glance, this point about concentration is true. Today’s Mag 7 companies account for 35% of the S&P 500. In contrast, the Mag 7 companies in 2000 represented only 15% of the index.

But is concentration always dangerous? Not necessarily, especially when the leading companies have strong earnings — and all of today’s tech giants have ample, diversified earnings. Many of these companies also have plenty of cash and are thus in a strong position to invest and increase their earnings power.

Things looked far different in 2000. Back then, most of the seven top tech firms’ value was based on expected future earnings from businesses yet to be developed. Given that most of the companies were generating little — if any — cash, most of the investment had to be funded by debt.

So, what does all this say about the risk of another dotcom-style correction?

The pullback after 2000 was brutal. Microsoft’s share price fell as much as 65%, and Amazon lost almost all its value at its low point. Meanwhile, Cisco, Intel and Oracle were down an average of 86%.

It took 17 and seven-and-a-half years, respectively, for Microsoft and Amazon to regain their peak nominal prices, while the other three took an average of 20 years to recover.

We are unlikely to see a repeat of this, based on my estimations. Today’s leading tech companies are more mature, have lower average valuations and, relatedly, much higher earnings.

On top of this, market structure is very different today, with more greater retail and private equity participation. Investors also now have a better historical perspective on many of these tech companies and would most likely have a huge appetite to “buy the dip” if and when a sell-off happens.

There’s good reason for this. Even though AOL and Yahoo! eventually met their demise, most of the other big tech companies of 2000 not only survived the crash, but also thrived and still dominate today.

I am not saying the AI bubble is not a bubble. There are indeed many parallels between today’s market and the run-up to 2000. I am merely pointing out that the magnitude of the bubble was huge in 2000, measured in terms of the equity price increases and PE ratios.

A correction is likely to come at some point. But, if we use the dotcom experience as a benchmark, the summit is quite far above where we are now, and even if we get there, the fall might be far less severe.

Reuters