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A repeat of dot com bust?

Last week was an interesting one for the stock market. After weeks of gains, the first sign of the crack in the stock market has finally appeared with all three major indices (DJIA, S&P500 and Nasdaq) ending the week with a steep decline. Amongst these three indices, Nasdaq suffered the worst decline with a drop of nearly 4% (the worst since March). In a matter of a few trading days, Apple (the world's only $2 trillion company) lost more than $200 billion in market capitalization. To put things in perspective, this amount of loss is bigger than the total current market capitalization of ExxonMobil.

With these happenings, most investors can't help but wonder if this is the beginning of another dot com bust in 2000.

Well, let's take a look at some facts and do some comparisons.

In both scenarios, we are seeing the Federal Reserve introducing a large amount of liquidity. In 2000, the dot com bubble was created or rather fuelled by a large amount of liquidity introduced into the market by the Federal Reserve. Back then, the amount of liquidity introduced was to manage the risks revolving around the so-called Y2K computer bug (for those of us who are old enough to remember that). The eventual bursting of the bubble was then caused when this amount of liquidity is then removed from the market. In today's context, the Federal Reserve is also introducing a large amount of liquidity into the market to manage the risks revolving around COVID-19. And there are worries about what will happen if this amount of liquidity isn't being managed well like what happened in 2020. Would this then trigger another round of tech bubble bursting?

Thankfully, initial signs are showing that the current amount of liquidity introduced isn't excessively allocated to the equities market even though we are seeing a rapid increase in the number of positions Robinhood investors (retail investors) hold in S&P500 over the past few months. To put it in simpler terms, not all the money introduced is being poured into equities exclusively. And that puts us in a slightly different situation as compared to what we experienced in 2000. Though, I would personally think that we would need to pay close attention to this in the coming months.

The current valuations of the technology stocks are also what worries most of the investors today. Most have the belief that the valuations of most of the technology stocks are now going through the roof. And that's actually quite a valid concern. For example, Apple's current P/E ratio is now around 40 and that's the highest P/E ratio the company has since 2008.

Taking that as an example, some could have immediately determined that the whole Nasdaq is overvalued at the same order of magnitude as compared to the dot com bust in 2000. Interestingly, this isn't really the case. P/E ratio for Nasdaq went as high as 200 during the dot com bust in 2000. Comparatively, Nasdaq's current P/E ratio is only around 28 and that's a far cry from 200. The main difference in the situation now is that the stock prices for most of the technology companies are partially driven by real performances in their earnings. Most of the big technology companies like Microsoft and Amazon etc are having record quarters as a result of the acceleration of technology adoption due to the pandemic. These companies have very robust business models and dominate their respective markets which in turn results in a very sustainable growth in their revenue. This situation is very different from the dot com era where there are no fundamentals driving the rise in stock prices for most of the technology companies back then. Back in 2000, investors were buying technology stocks simply because they believed the dot com companies would eventually be profitable, no matter how detached that belief is from reality. Fast forward to present days, you no longer need to hope or believe those big technology companies will eventually be profitable because they are already very much profitable now.

That's not to say that there's nothing to worry about in the current situation. In fact, one of the biggest red flags we are seeing in Nasdaq now is the huge dominance of the top few companies. The top six companies (Apple, Microsoft, Amazon, Alphabet, Facebook and Tesla) now made up around 40% of the Nasdaq in terms of market capitalisation. Such dominance is eerily similar to what you are seeing during the dot com era where the top six companies (Microsoft, Cisco, Qualcomm, Intel, WorldCom (already bankrupted) and Oracle) made up around 36% of the Nasdaq in terms of market capitalisation. (You might like to refer to this research article for more information on Nasdaq from 1999 to 2013). Should any of these six companies suffer any miss in earnings expectations, you would see the whole Nasdaq crumbling down like a pack of cards.

On the first sight, there may be a few loose similarities with what we are experiencing now as compared to the dot com bust in 2000. However, if you were to dig deeper into it, you would realise that some of these so-called similarities could be rather different when you focus on the fundamentals and realise the whole situation surrounding the equity market now is a slightly different animal.

As always, I strongly advocate investors to be diversified in their portfolio and not focus their entire portfolio on a single sector or stock. While this might not be a repeat of the dot com bust, you would not want to have a portfolio fully focused on Nasdaq (especially with the huge dominance of just a few companies). A correction could still happened and you would probably not want to experience the full brunt of it. A portfolio diversified across different asset classes would still be your best insurance in all market conditions. If you are interested to find out more, check out my other articles on asset allocation here and here.

Till the next time.

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