James Mackintosh warns in The Wall Street Journal that patterns that preceded the Dotcom crash are once again taking hold of the stock market. He writes:
But the forgotten story of the time was the extreme valuations reached by some very boring businesses as bond yields fell in the months before LTCM collapsed. From the start of 1997 to August 1998, the 10-year Treasury yield dropped from 6.4% to 5.4%. The fall justified higher valuations for companies with reliable earnings. The market, as usual, took it to excess. Coca-Cola led the way with a forward price/earnings ratio that almost doubled to 50 (!), while the consumer-staples sector as a whole went from under 19 to 25. When the Fed’s rate cuts restored confidence and bond yields rose, those valuations fell all the way back, even before the dot-com bust took down the entire market.
A similar pattern is visible today. Dot-coms have been replaced by speculation on electric cars, but many of the same safe, reliable earners are again trading on premium valuations because of low rates. With the 10-year Treasury now at 0.6%, a dividend yield of 3% on Coca-Cola or PepsiCo looks like a bargain. Until the story changes, and it doesn’t.
Inflation. In the early 1970s, the Nifty Fifty stocks offered investors a nice, safe way to avoid the problem of a bond yield sharply down thanks to the recession at the start of the decade. Reliable growth and decent earnings pushed companies such as IBM, Kodak and, again, Coca-Cola (then at 49 times trailing earnings) and PepsiCo to unwarranted valuations.
When inflation ran out of control and bond yields began to rise, the cheap money that had underpinned this excess vanished and valuations fell back. Hardly any lived up to their promise.
No one is paying 50 times for Coke right now, so there’s scope for stocks to rise a lot further yet. Wild speculation is still limited to a select group, led by Tesla. But we’re already at the point where extended valuations for the supposedly safe growth stocks are vulnerable to any surprise good news on the economy that pushes up bond yields. Investors need to remember that reliable earnings don’t make for reliable stock returns if they pay too much for them—and any sign that interest rates aren’t staying at close to zero pretty much forever will mean they paid too much.
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