Are Stocks Overpriced or Are Talks of an Impending Crash Overblown?

After the Dotcom Bubble crashed in 2001, many people pointed out the many similarities that the boom and bust had with other periods of rapid share price growth and the even faster declines that followed.

By overlaying graphs of other periods of rampant speculation – like the Bitcoin bubble in late 2017, Tulip Mania in 1636 and 1637, and the Wall Street Crash of 1929 – it’s possible to see similar patterns in the way excitement, speculation, and the fear of missing out all combine to drive asset prices higher until the trend suddenly and violently reverses.

The Wall Street Crash was caused, in part, by the widespread availability of credit that was being used to invest in stocks. Similar things happened during Tulip Mania, with many people expecting the price of bulbs and flowers to continue rising indefinitely.

Today, as several of the world’s biggest stock market indices continue to set record high after record high, many pundits are asking whether we should expect another market correction or even a full-blown crash in the near future.

But, despite several years of forecasts that described imminent doom for investors and the companies they have bought stocks in, the apocalyptic predictions haven’t materialised. However, there are some similarities that should be cause for concern for investors, though there are also plenty of reasons to be positive about many of the companies with high valuations.

Record Profits

The Dotcom Boom, Tulip Mania and the 2017 Bitcoin bubble all have one thing in common: they were driven by unfounded speculation. In the 1990s, most internet companies were chasing growth through round after round of funding, and almost none made a profit. In 1636, the underlying value of tulips didn’t increase. They were still only useful for a small number of things, just as they were in 1635 and are now 2021. In 2017, Bitcoin wasn’t materially different to how it was in 2016 or 2018.

In all three instances, returns were only achieved by selling the asset the investor held, not from any sort of dividend.

Things are materially different today in most (but not all) cases. Many of the companies that have seen their share prices rise have also been making record profits. For example, Amazon, which has seen its share price rise by more than 50% since early April last year, increased its revenue by 38% and its net profit by 84% in 2020.

The gaming industry, where most publicly-traded companies have enjoyed share price rises of between 50% and 100% in the last year, has also been making record profits. This has been driven by growing demand for all types of video and online games and a move to microtransactions.

This new revenue model has been adopted by companies right across the industry, including major brands like PokerStars and Valve Corporation. In fact, in 2017, Strauss Zelnick, the CEO of Take-Two Interactive, told investors that “recurrent consumer spending” (microtransactions) is the “way of the future”. His prediction was right; most of the company’s games, including Grand Theft Auto, NBA 2K, and Red Dead Redemption, now include them and generate around 50% of its revenue.

This isn’t uniform across the market though. Investors have piled into Tesla, GameStop, and AMC, giving the companies valuations that don’t reflect their financial performance. Many non-tech companies haven’t fared as well as the gaming industry or Amazon, though this hasn’t stopped markets from rising still.

Low-Interest Rates

Interest rates have never been as low as they currently are. We’ve lived in an era of low base rates for over a decade now, as central banks seek to encourage consumer spending to stimulate the economy. Most nations target a rate of inflation of around 2%. But over the last 12 years, it has averaged 1.5% in the US and in 2020 was just 0.62%.

With ultra-low base rates, banks are also offering pitiful interest to their savings customers. Most consumer savings accounts in the United States and the United Kingdom pay around 0.1%.

To get inflation-beating returns, many are being forced to put their money into the stock market, driving up share prices, even if other factors should force them down.

Until banks begin to offer more attractive interest rates, it seems likely that investors will continue to place their money in riskier assets.

Statistical and Technical Metrics

Many investors use ratios to gain insight into the market. During the Dotcom Bubble, the price-to-earnings (PE) ratio of the Nasdaq reached 200, meaning the companies in the index were worth 200 times the amount of money they made that year. A similarly high ratio was seen in Japan during the 1991 Japanese asset price bubble. At that time, the country’s Nikkei 225’s ratio was 80.

The long-term PE ratio of the S&P 500 is around 15. In 2009, it reached 70.91. As of April 2021, it has risen to 40.93, the third-highest it’s ever been. The two times it was higher were just before the Dotcom Bubble and during the 2008-09 financial crisis.

The PE ratio is just one of the metrics that suggest a correction is imminent, with many others also hinting that a sudden drop is on the cards.

There’s no way of predicting the future, especially not when it comes to the stock market. It does seem that shares are overpriced and that a correction will happen at some point soon. However, given that many of the companies driving the growth are raking in record profits and investors have nowhere else to go to make reasonable returns, we may be in uncharted territory.

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