Is a 90s-style bubble forming in mega-caps? Jurrien Timmer looks at the evidence.
by Jurrien Timmer, Director of Global Macro, Fidelity Investments
Key takeaways
- The ongoing strength in mega-cap growth stocks has many investors wondering if there is another bubble in the making, not unlike the dot-com bubble of 2000 or the “Nifty Fifty” period of the early 1970s.
- But, so far at least, the hefty price gains have been justified by solid earnings growth. As a result, the valuation spread between large-cap growth stocks and the rest of the market is nowhere near the extremes of the dot-com period.
- Until valuation levels reach extremes or the fundamentals change (perhaps through antitrust regulation), it’s quite possible that these stocks will continue to lead the market.
- In the meantime, earnings season is wrapping up with relatively good news—85% of companies have beat estimates by an average of 22%.
- The price of gold has surged recently, perhaps due to speculators and a "money illusion" created by combined monetary and fiscal policy response.
The FANGs1 have been all over the news lately, rocketing to new highs while the average stock remains well below the February highs, and last week they posted huge earnings gains to boot. It’s a winner-take-all kind of world right now, and mega-cap tech stocks seem not only immune to COVID, but actually thrive on it.
This has led many a strategist and lay bystander to conclude that we are in another tech bubble, just like 2000. Pointing out the supposedly narrow leadership (which actually hasn't been true for most of the recovery) has been part of most perma-bears’ playbook for hating on the market.
So let’s take a closer look to either confirm or debunk this argument.
1990s compared to the Nifty Fifty era of the mid 1970s
During the late 1960s the cyclical bull market which spanned from October 1966 to November 1968 produced a huge bubble in retail speculation. Speculation in tech and space companies was a favorite pastime among retail investors as the secular bull market of 1949–1968 was in its final innings.
The recession of 1970 produced a painful bear market. During that decline and the recovery that followed (into the January 1973 peak), the public remained absent and the stock market became dominated by institutional investors. Having been burned by both the recession and the bursting of the speculative bubble, these institutions were only willing to buy tried-and-true stocks with bullet-proof earnings. This handful of mega-cap stocks were referred to as the Nifty Fifty.
Those stocks indeed withstood the vicious 1973–1974 bear market, and even held on to their performance during the recovery in 1975. Their earnings never wavered but it came at a price, in the form of ever higher P/E multiples. It was only when inflation became the market’s mortal enemy during the second half of the 1970s that the Nifty Fifty buckled under from collapsing valuation multiples.
Decades later, during the late-1990s, the market’s leadership once again became dominated by a handful of mega-cap growth companies. Once again, retail speculation dominated in 1999 and 2000, with stories galore of average people quitting their jobs to become speculators.
Eventually, the dot-com bubble burst and what went up came back down. Now it seems we are yet again in a period (since 2015 or so) during which a handful of mega-cap growth stocks are leading the market, through bull and bear cycles. It’s the Nifty-Fifty, Part 3.
Earnings growth
The chart below shows the 5-year compound annual growth rate (CAGR) of the top 50 and bottom 450, with the spread at the bottom. The bottom panel highlights nicely the 3 periods of relative performance between the mega caps and the rest of the market. During the original Nifty Fifty period, the top 50 outperformed the bottom 450 by 620 basis points (bps). A basis point is 1/100 of a percent. During the dot-com period that spread grew to 1140 bps. Currently it is 670 bps.
The CAGR for the S&P 500 since 1962 (the start of this time series) is around 10%, which highlights just how unusual the late 1990s were in terms of absolute returns. At the peak in 2000, the top 50 were sporting a 5-year CAGR of 34.3%, while the bottom 450 produced 23.4%.
As for the market cap weight of these 2 cohorts, currently the top 50 comprise 55% of the market and the bottom 450 are 45%. Back in 2000, the top 50 were 61% of the market’s capitalization, and in 1973 it was 66%.
The difference between the 2 cohorts becomes more evident when looking at sector weights. By definition, all 3 iterations of the Nifty Fifty have been growth-oriented, but what is considered growth today (tech, health care, communication services) is not necessarily what was considered growth 50 years ago. For instance, the materials sector was a large portion of the top 50 in the 1960s.
OK, this is all well and good, but none of the above answers the question of whether we are in another mega-cap bubble. To answer that question, by definition, we have to look at valuation. After all, you can’t have a bubble if valuation has not been bid up to very high levels.
The chart below shows the P/E multiple for the top 50 vs. bottom 450. Here we are taking trailing earnings excluding negative earnings in order to smooth out the data (plus there were no consensus estimates prior to the 1980s).
The original Nifty Fifty produced some high valuations for the mega-caps, with the top 50 reaching a P/E of 25.9x in early 1973 (the cycle peak). At that same time, the bottom 450 traded at a 20.4x multiple.
Then came the bear market, and the top 50 P/E fell to 10.5x while the bottom 450 fell to 6.4x. From there, the recovery brought the top 50 back up to 21.0x while the bottom 450 only made it up to 12.6x. After that, inflation took over and all multiples fell to single digits.
At the peak of the dot-com bubble the top 50 produced a P/E ratio of 40.2x while the bottom 450 traded at a mere 19.0x. That very large spread (a bubble indeed!) was completely reversed by the time that the bear market was over in late 2002 (after a 53% decline for the S&P 500).
Currently, the top 50 are trading at a P/E of 25.7x while the bottom 450 are at 20.8x. Yes, the mega-caps are running away from the pack, but the difference is not even close to the dot-com bubble, in my opinion.
Looking at this another way, in the chart below we have the relative total return overlaid against the premium/discount of the top 50 P/E vs. the bottom 450. Again, there is a clear trend in place of mega-cap dominance, but the top 50 P/E has only swung from a 22% discount back in 2014 to a 23% premium in 2020. That pales in comparison to the dot-com era, when the top 50 P/E went from a 3% discount to a 104% premium. The same is true in the 1970s: The top 50 P/E swung from a 9% discount to an 84% premium.
The conclusion is simple: While mega-caps are dominating on the return side of things, their dominance appears to be justified by their relative earnings power. As a result, while relative valuations have expanded as they have during previous mega-cap regimes, they are nowhere close to the levels which, in past cycles, have led to a bursting bubble.
All of this tells me that the leadership by mega-cap growth stocks can probably continue for some time to come, until either the fundamentals change (for instance through regulation, like breaking up big tech companies) or the valuation difference becomes more extreme (or both).
In other news: Earnings season
Earnings season is well underway, and so far, it has been a doozy. With 85% of companies beating their estimates by an average of 2,200 bps, the Q2 growth estimate has bounced from −46% to −35%. Impressive.
While the market still trades above even the 2022 earnings estimates (red line in the chart below—Price vs. earnings), that line is now edging higher. It was always a question of (a) price needs to come down, (b) estimates need to come up, or (c) the P/E will remain higher than normal (because of financial repression2). It’s probably a combination of all 3, but it’s good to see the earnings line drift higher now.
The earnings improvement has not fixed the market’s declining breadth problem, however. Despite the S&P 500 Index (SPX) being back at its recovery highs, the percentage of stocks trading above their 50-day moving average continues to diverge. It is now at 65%, down from 83% at the most recent high in July, and 98% at the June 8 momentum peak.
Meanwhile, the Russell 2000 continues to barely hold on to its uptrend line. It’s a tale of 2 markets.
The other side of that coin is, of course, large-cap growth, which on Friday made a new all-time high.
Money illusion
Finally, with the divergence between nominal rates and inflation expectations widening even further last week, gold surged to just under $2,000. One of the most reliable drivers for gold is real rates, so this is not surprising to see.
I believe that the speculators may be behind the moves as well, especially now that bitcoin has finally joined the party. While it gives me some pause that precious metals have gone from “stealth” bull market mode to “widely recognized,” that doesn’t mean it is about to end.
While there are different ways to interpret this divergence between nominal rates and inflation expectations, I would see this as a victory for the Fed. After all, what better outcome for the Fed (and the markets) than the ability to keep nominal rates repressed near zero while at the same time conjuring up animal spirits in the markets (manifested by a rally in inflation spreads and a narrowing of credit spreads)? It’s sure better than the deflationary death spiral of the 1929–1932 period.
But the result of all this is a stock market that looks a lot better in “fiat” terms than in hard currency (gold) terms. When priced in gold, the SPX only retraced 39% of the February–March decline (as opposed to 90% in fiat), and it has since given up about half those gains. That’s called a money illusion, and it’s the price to be paid for reflation.
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About the expert
Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.
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