The stock market recovery has echoes of the dot.com bubble

This article was originally published in The Telegraph.

WE’RE a year on from the bottom of the 2022 bear market and, even after the fall from July’s high, shares stand 20% higher than they did last October.

That’s welcome after the disappointment of last year in which, unusually, stocks and bonds fell in tandem. But it doesn’t tell the whole story.

If you have been invested exclusively in the seven tech stocks which have driven the market higher over the past 12 months, you’ll be happy. But the experience of most investors has inevitably been more nuanced than that.

An equal-weighted index of the US’s leading shares - one that attaches the same importance to the smallest companies in the S&P 500 as to the Amazons and Apples that dominate the benchmark - has gone nowhere over the past two years. It has moved sideways in a broad channel since late 2021, and currently it is bumping along the bottom.

If you scratch further beneath the surface, looking instead at the Russell Microcap index, a measure of America’s smallest quoted companies, you will see a market that has been falling consistently for two and a half years. The index is 20% lower than in the spring of 2021 and no higher than it was seven years ago.

The outperformance of a handful of big growth companies in the US is reminiscent of two earlier periods in which a small number of the market’s largest stocks grabbed the headlines and obscured what was going on for the vast majority of shares.

In the early 1970s, the market leaders were dubbed the Nifty Fifty. During the late 1990s, the boom years were, more prosaically, labelled the dot.com bubble, although the poets did return when the music stopped to witness the Tech Wreck. Because history still rhymes, we might call today’s winners the Seven from Heaven.

The Nifty Fifty years were characterised by a flight to safety as investors grappled with a testing economic backdrop. The only shares anyone wanted to buy were the large, defensive ‘one decision’ stocks that could be bought and forgotten.

The likes of IBM, Johnson & Johnson, Xerox, and Kodak. Companies that at the time felt impregnable. They outperformed the rest of the market during the early 1970s bull market, and they stayed ahead during the savage bear phase that followed in 1973/4. By the middle of the decade the Nifty’s average valuation multiple was twice that of the also-rans.

That yawning valuation premium ultimately sowed the seeds of the Nifty Fifty’s demise. But it was not enough on its own. That required a catalyst, which duly arrived after the Arab oil embargo in the form of spiralling inflation that undermined stocks indiscriminately. The valuation premium evaporated and by the time the market bottomed in real terms in 1982 there was no trace of investors’ love affair with the former market darlings.

The late 1990s tech bubble was similar but different. Once again, investors latched onto a handful of stocks and drove their valuations to nose-bleed levels. The share price of Cisco grew seven-fold in a couple of years from 1998 to 2000 before coming all the way back down again by 2002.  

But the focus on tech stocks was not born out of fear, as it had been 25 years earlier. This time the fever was a result of over-optimism and greed. The internet was going to change everything, so no price was too high for a share of the action.

Once again, the set-up for the reversal was excessive valuation, and multiples once again peaked at twice the average for the rest of the market. This time, however, the trigger for the reversal was different. Not inflation, but rising interest rates, fraud, and gravity.

The market’s obsession with the Seven from Heaven carries echoes of both previous bubbles.

Investors are confident that the winners during the next chapter in the technology story - AI in particular - are already in place. Once again, they are happy to pay to play. But there is a defensive case for these stocks too. In a world that’s looking recession in the face, with potentially sticky inflation and higher for longer interest rates they also look like a port in the storm.

So where are we today? How close to the pricking of the bubble? Arguably some way away. For one thing, the valuation of the Seven is only around 1.4 times higher than for other leading stocks. If interest rates fall as the economy slows then it is plausible that investors will be prepared to pay even more for their reliable earnings.

But there are plenty of catalysts lining up to signal the end of the party. Inflation, higher for longer rates, a long list of compelling alternatives offering high income with fewer risks. Perhaps a cyclical recovery will make value stocks, at a fraction of the price of their growth counterparts, look more relatively interesting.

And when it happens, we can expect all the parts of the market which have played second fiddle for so long to enjoy their moment in the sun.

Active funds that haven’t stood a chance while just seven shares drove the index higher. Non-US stocks. Commodities. Smaller companies.

And, if history is any guide, that process will take years to unfold. Typically, the cycle has taken 30 years - 15 years for the pendulum to swing fully one way and 15 for it to come all the way back again. That’s good news. It means you do not have to time the market to perfection. Just make sure that your portfolio is diversified enough so you are not left out of the rotation when it picks up pace.

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