jhg,
I define a bubble as a condition in which the price of a stock (or commodity or any other economic good) cannot be justified on economic grounds. I don't consider it a pejorative, any more than describing somebody with a body temperature of over 100 as having a fever to be a pejorative description.
Think about the following scenario. Suppose you have a basket of stocks that demands an expected holding period rate of return of at least 18% based on cost of capital and volatility considerations. Suppose, further, that the expected growth in cash flow is 35% pa. If the trailing P/E is about 200 (as in the case of CSCO), how many years of 35% growth must already be discounted into the current price of the stock to justify the P/E multiple?
Under this scenario, each year the P/E would be reduced by 14.4%. Now suppose that we agree that the terminal P/E of such a stock should be about 45 (which implies plenty of growth still ahead of it). The answer is about 11 years!
A simpler way of thinking about this is to ask yourself why growth in the price of the stock has exceeded expected growth in cash flow. The only rationales are:
1. Visibilty of future earnings has increased, reducing the riskiness of holding the shares; and/or
2. Interest rates are falling.
Neither of those cases are true. Hence, I believe that the inflated prices of many stocks on the NASDAQ are indicative of a bubble.
But that is not the case with many "old economy" stocks. So it is not a case of elitism. What we are seeing are normally rational people eschewing reason in favor of making a quick buck. For example, I once asked an acquaintance about XYZ, a company in which he invested heavily. This individual couldn't even tell me what business the company was in! His glib reply to me was, "they make money", which, in reality, meant that the price of the stock was going up. He had no idea of the company's earnings.
TTFN,
CTC |
