It’s easier to identify market bubbles than to time their demise.
At its peak in 2000, Cisco traded at more than 60 times trailing revenues. From that peak in March 2000 to the lows in October 2002, the stock was down about 90%. Indeed, if you had bought Cisco at the March 27, 2000 peak, and held until today, you’d still be down more than 16.6% some 23 years later, even including all dividends paid.
More recently, Tesla reached a valuation of 25.5 times revenues on November 4, 2021, and the stock is down 47.5% since that time.
Simple math suggests it's exceedingly difficult for a stock, especially a large-cap stock with a significant market share, to grow at a fast enough pace for long enough to justify a valuation of 25+ times trailing sales. The potential for a growth hiccup or disappointment to derail the story and lead to a quick whoosh lower in the stock is just too high.
Accordingly, the history of large-cap stocks trading at 25+ times revenues isn’t encouraging. I did a quick search, based on data since 1998, looking for stocks with a price to sales ratio over 25 times and a market cap ranking among the 50 largest stocks in the S&P 500.
The results look like a “Who’s Who” of terrible investment ideas. The Cisco buy in March 2000 and Ebay Inc (NSDQ: EBAY) in June 2004, a stock which went on to decline 50% by the middle of 2006 and 77.6% to its March 2009 lows are just two of the more egregious failures.
Well, today, market darling Nvidia (NSDQ: NVDA) trades at 37.7 times trailing revenues and a market cap just under $1 trillion – is there really much doubt that’s a bubble too?
Yes, I know there are reasons for excitement about artificial intelligence (AI) and the potential for earnings growth at a company like NVDA. However, there were valid reasons for optimism about growth in Internet traffic and Cisco’s leverage to the trend back in 2000 – the Internet undeniably changed our lives – yet, that didn’t forestall a 90% decline in the stock.
However, while these stocks clearly represented bubbles, that doesn’t mean they’re about to burst. Cisco was expensive in March 2000; but, it traded over 25 times sales at times in the summer of 1999 – an unsustainable level – yet still managed to jump an additional 148.5% to its ultimate peak less than a year later.
And NVDA, which looks expensive today, has traded above 25 times sales on multiple occasions since September 2020 and as high as 34 times sales in late 2021. And, while the stock did collapse more than 66% from its peak in December 2021 to its mid-October 2022 lows, this year’s rally has the stock at a fresh all-time high, up 169.2% year-to-date.
It takes time for excess optimism to fade and collapse and, as British economist John Maynard Keynes once quipped, markets can remain irrational longer than you can remain solvent.
In short, terrible breadth, excessive valuations and parabolic advances in large-cap story stocks and themes like AI – all features of the current market – are characteristic of the final throes of an equity bubble.
However, it’s unclear whether “the pop” and bearish reckoning is imminent, or the rally has a bit further to run before the next leg of this downdraft is underway.
I’m recommending a three-pronged strategy for the model portfolio to invest through the current market environment:
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