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<<The Big Picture - Is This a Bubble?
08-Sep-03 08:19 ET
[Briefing.com - Dick Green] Briefing.com has been resolutely bullish since March. It is still our view that over the long term, stocks offer the best way to participate in the wealth creation machine known as the US economy. Recent trading activity, however, raises concerns.
Long Term Value in the S&P 500
Briefing.com has written on numerous occasion about our view that the market is reasonably valued, and has long-term upside potential. Almost all of that analysis has focussed on the S&P 500 index, which is the most significant index for long-term investors. In that index, financial and health care stocks together make up about 34% of the index. Information technology stocks make up just 18% of the index.
The valuation analysis on the S&P is based on likely strong earnings growth over the next year, and the relationship of earnings yields on stocks to interest rates. Valuation, however, is not so compelling in the Nasdaq.
The Nasdaq index is significantly different than the S&P 500 index. It is widely recognized that the index is made up largely of technology firms, including biotech and telecommunications firms. Trading in these stocks has taken on a bubble mentality not dissimilar to the late 1990s.
What is a Bubble
When trading becomes disconnected from any foundation in value, the market can be said to be experiencing a bubble. That is, if:
* Stocks trade only on the direction of the news, rather than on connection to valuation, and if
* Stock values are high, and expected to go higher because they are heading upward,
then it is fair to say that the market is experiencing a bubble mentality.
The Nasdaq has reached that point.
A Huge Rally on Meager Fundamentals
Economic growth is moving sharply higher. The experience of most traders over the past ten years is that when this happens, tech stocks are some of the first firms to see the benefits. The fact that that has not yet happened has not deterred this line of thought in the least.
On any given day, the following are likely to top the Nasdaq most active list. The table below presents revenue growth for the current fiscal year (1) with the stock change so far this year.
- Revenue Growth Stock Increase 2003 % of Nasdaq Index
MSFT 13.5% 9.8% 9.76
INTC 3.3 84.4 6.08
CSCO -0.2 55.8 4.80
ORCL -2.1 21.3 2.79
AMAT -10.0 64.7 1.69
SUNW -8.5 34.9 0.54
PSFT -0.8 5.5 0.93
KLAC -19.9 64.6 1.24
Nasdaq 100.00
As the table clearly shows, the tech stocks that have rallied the most have not yet seen any pickup in revenue.
The Growth Just Isn't There
The market is a forward-looking creature. It is fair to suggest that the market is logically looking forward to significant revenue and earnings growth from these companies. We respectfully disagree. Most of the technology companies above have reached a mature level in their business cycle. They are not necessarily great growth stories any more, and won't be even with extremely strong real GDP growth in the second half of the year.
There are some encouraging signs. Intel (INTC) is showing signs of a significant pickup in revenue. That raises hopes for other companies. But it is not at all clear that enterprise software companies such as Oracle (ORCL) or PeopleSoft (PSFT) will see a turnaround in revenue growth just because Intel does. Nor is there necessarily any reason to believe that Cisco (CSCO), as large as it is, will experience a strong upturn in revenue just because Intel is grabbing market share.
The debate on the degree of the coming upturn in technology revenue is engaging. However, consider what happens if real GDP does hit 5% growth in the third quarter, and 4% in the fourth quarter, as many economists now expect. What if Cisco sees only a marginal increase in revenue during that same period? Will the fact that Cisco trades at 41 times earnings and 7 times sales matter at that time, if the expected strong growth curve is not evident?
We doubt that many analysts or traders care right now.
Trading on Incremental Growth
Almost everyone in the market today knows that semiconductor stocks lead the market. If the market is going higher, the SOX semiconductor index will go up even more. The SOX will also lead on the downside. This is the conventional wisdom of those that have traded over the past six years. This has made the SOX index almost like a futures contract on the overall market. A leading index with leverage.
It wasn't always this way. There was a time when semiconductors were considered a cyclical industry that should trade at low PEs. Over time, the semiconductor stocks may return to something reflecting the actual fundamentals of the industry, but that isn't the case today.
Instead, right now, many technology stocks and semiconductors in particular are trading on incremental news without regard to how that ties back to valuation. If Intel raises guidance, it doesn't really matter how much, it just becomes a reason to trade the SOX higher. If Cisco says things don't look as bad as they did last month, no one really asks what that means for the value of the business, they just start trading the stock higher and analysts raise price targets as the stock goes up.
What It All Means
The Nasdaq and many of the top stocks in the index are reflecting bubble mentality. The stocks have simply become trading vehicles without any real concern for valuation. Analysts have been piling on, raising price targets and ratings so as not to look bad, while only modestly raising earnings estimates. This creates a risk for the overall market.
There is no logical reason to think that technology stocks couldn't back down to reasonable valuations without pulling the overall market down. But we wouldn't put our money on that. If tech stocks take a hit, the SOX is once again likely to prove a leading indicator and have a negative influence on the overall market.
Bubbles always last longer than almost anyone expects, and this one probably will as well. But the risk is rising. Briefing.com is concerned that the recent trading activity increases the risk of a correction.
This in no way affects our belief that the broader market is fairly valued, and that the current upturn in the economic cycle will produce outstanding profit growth for the S&P 500 in the third and fourth quarters. Long-term investors should stay the course. The possibility of a pop in the tech bubble, however, raises risks for the overall market. Heading into the traditional period of September and October anxiety, this is of particular concern.
Comments may be emailed to the author, Dick Green, at dgreen@briefing.com.
(1) Revenue growth is for the current fiscal year, even if only a partial year, compared to the same period in the prior fiscal year. |
