Bubble's Gone, but Bubble Thinking Still Distorts This Market

When people talk about how a lack of visibility has made investing difficult, they are usually talking about the future. In an uncertain economic environment, it is hard to know when corporate profits will start to recover, and how far they will fall beforehand.

But what happened in the past has just as much to do with the increasingly tricky investment environment. Both the inflating and the bursting of the high-tech bubble -- considering a just-concluded first quarter in which the Nasdaq lost a quarter of its value -- have continued to distort how people view this market.

"It ruined a lot of our models," admits Merrill Lynch quantitative strategist Rich Bernstein. The rules of thumb that many investors used as a guide got turned on their head by the Nasdaq bubble, and many of them have yet to right themselves.

Cause and Effect

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Consider: Early last year, Bernstein seemed so wrong that he wasn't getting many calls from clients. Back then, he was advocating investing in what he called "the not-so-nifty 450" -- the bottom 450 stocks in the S&P 500. His research had shown that whenever the profits cycle accelerates, as it was doing with great abandon back then, the market tends to broaden. But the bubble psychology around the Nasdaq changed that. Investors were going after a relative handful of stocks, forcing prices on those stocks higher, forcing other investors to give up nontech holdings and join the fray. The majority of stocks in the S&P 500 were underperforming the index.

The Fed kept on hiking rates, and pretty soon it became clear that the U.S. was going to be heading into economic headwinds, and profits growth would slow. So what happened? The market broadened -- the exact opposite of what it was supposed to do -- because the run-up in big-cap Nasdaq stocks was getting unwound. More stocks in the S&P 500 have been posting better performances than the index than at least 1986, when Bernstein's data starts. Moreover, if you had invested in the companies in the S&P a year ago on an equal basis (the index is capitalization-weighted), you would actually have a positive return at this point.

Besides making it hard to figure out whether one should be looking for continued breadth in the market or a narrowing, the Nasdaq bubble damaged a lot of valuation models. Consider: The average price-to-earnings ratio on the S&P for the last five years is around 24, which makes today's 20 look pretty cheap. But so much of that has to do with a couple of years in which valuations got excessive, and the S&P's P/E rose as high as 31. The five years prior to 1999, when things really got cooking, the S&P's average P/E was around 18.9.

Defining Deviancy Down

"In terms of expectations on earnings growth and margins, what's your definition of normal?" asks Bernstein. "In the past two years, your definition of normal is very distorted."

The bubble also hurt models that seek to determine the fair value for the S&P by looking at the relationship between Treasury yields and earnings yields. Inherent in such models is a "risk premium" -- on an absolute basis, stocks need to have a higher expected return than Treasuries, because Treasury returns are virtually guaranteed while stock returns are not. To figure out what the appropriate risk premium for their models is, strategists look to the historical relationship between stocks and bonds. But there history fails them, because in the midst of the bubble the market was treating stocks as if they were less risky than bonds. This makes the average risk premium a good deal higher than what investors might more comfortably assign to stocks.