FRBSF Economic Letter
2001-17; June 1, 2001
The Stock Market: What a Difference a Year Makes
Stock prices have been on an extraordinary ride in the last two and a
half years, soaring to phenomenal heights and then plunging at head-spinning
rates. At their peaks, the NASDAQ composite and the S&P 500 were up
579% and 233%, respectively, compared to the beginning of 1995 (see Figure
1). Since the peaks, the NASDAQ composite has fallen more than 50%
and the S&P 500 has dropped 15%. Nevertheless, as of the third week
of May 2001, both the NASDAQ and the S&P 500 are up 196% and 181%,
respectively, since the beginning of 1995. This Economic Letter
takes a closer look at the stock market: First, what happened to the NASDAQ?
Second, do current stock price valuations make sense?
The gyrating NASDAQ
Although almost 6,000 stocks are traded on the NASDAQ, that market is
dominated by technology companies. At the peak on March 10, 2000, the
20 largest domestic companies in the NASDAQ were in the technology sector,
and together they accounted for over one-third of the total capitalization
of that market. Quite amazingly, 6 of these top 20 firms were losing money
as of the fourth quarter of 1999. Today the top 20 stocks in the NASDAQ
include a few firms from non-tech sectors, but tech stocks still account
for the lion's share. So, in order to understand the NASDAQ, one must
focus on technology stocks.
Due to advances in information technology (IT), and a little bit of Y2K
fear, business investment in IT equipment and software was growing at
a much faster clip than non-IT business investment, particularly during
the last five years. Specifically, between 1995 and 2000, capital investment
in IT equipment grew at a 22.7% compound annual rate, after adjusting
for inflation, compared to a 5.1% compound annual rate for non-IT related
As a result, revenues and earnings at technology companies in general
grew very rapidly, particularly in 1999. Between 1998 and 2000, total
earnings in a constant sample of 356 S&P 500 companies grew at a compound
annual rate of 21%, up from what was already very fast growth by historical
standards. Total earnings for the technology sector, based on a constant
sample of 523 publicly traded tech companies, grew at a staggering 38%
annual rate during the same time period, almost twice as fast as the S&P
With supranormal growth among technology companies, the increasing adoption
of electronic commerce, and increasing evidence of productivity gains,
widespread optimism prevailed in the stock market. In other words, we
had what can be called a "virtuous cycle." Investors were very willing
to provide financing to technology companies, especially for technological
innovations (from dot-coms to telecommunications-related technologies).
The amount of initial public offerings of stocks shot up in 1999 and peaked
in the first quarter of 2000. With abundant financing, technology start-ups
and telecommunications providers invested heavily in IT. Moreover, traditional
companies followed suit as a defense strategy. And this investment cycle
fed on itself. Note that during this cycle, a fair amount of IT investment
was made with very little regard to consumer demand.
Good times usually don't last forever, and so it was with this virtuous
cycle. Before long, the "vicious cycle" began. With decreasing marginal
returns on IT investment, the Y2K threat gone, and evidence of overcapacity
in certain IT infrastructures, firms scaled back their investment in IT.
Consequently, revenues and earnings growth among technology companies
slowed in the second half of 2000. Unable to meet Wall Street expectations,
tech stocks got hammered, particularly those with very high price-earnings
ratios (P/E) that were associated with very high growth expectations.
Realizing the risks involved in investing in tech companies, investors
changed course. They either demanded a high rate of return for providing
capital to these companies, as evidenced by the widening credit spread
in the bond market, or they cut off financing altogether, as evidenced
by the drying up of equity IPOs. Without infusions of capital, some firms
had to scale back their investment in IT. Other firms facing cash flow
problems were forced into bankruptcy, and they, in turn, liquidated their
IT equipment into the secondary market, further damping the demand in
the primary market. This led to a downward spiral in tech stock prices.
According to this analysis, to the extent that the current slowdown in
the tech sector was caused by overinvesting in IT, lowering interest rates
is unlikely to revive business investment in IT quickly. It will take
time for the existing IT capacity to be absorbed at the consumer level
before firms start to invest in IT again.
Do current stock valuations make sense?
Understanding what contributed to the rise and fall of stock prices in
the NASDAQ is relatively straightforward. A much harder question is: Do
the current valuations make sense—especially for tech stocks whose prices
have fallen so much? To answer this, it is useful to look first at the
relative valuation of tech stocks to non-tech stocks before looking at
the valuation of the broad stock market in general.
Figure 2 shows the weighted average P/E
ratio of all the technology companies in the S&P 500, the weighted
average P/E ratio of all the non-technology growth companies in the S&P
Barra Growth 500, and the P/E ratio of the S&P 500 Index. In calculating
the average P/E ratio for technology companies and growth companies, only
stocks that have positive earnings are used, because the P/E ratio is
not meaningful for companies that have no earnings. Before 1996, the average
P/E ratio for tech stocks closely tracked the market average, measured
by the S&P 500, while growth stocks were selling at a premium due
to their growth potential. In 1997, tech stocks started to command a premium
and on average were selling at a multiple that was similar to non-tech
growth stocks. Beginning in mid-1998, the run-up in tech stocks pushed
their P/E ratio to more than double that of non-tech growth stocks at
the market peak. Currently, the P/E ratio of tech stocks is below the
P/E ratio of non-tech growth stocks but is still higher than that of the
The reason that the market awards a higher P/E ratio to both technology
companies and non-tech growth firms is because of their supranormal growth
potential. To delve deeper into the quality of earnings between tech and
non-tech growth companies, it is instructive to compare their earnings
growth and earnings volatility.
The weighted average five-year compound annual growth rate of earnings
for technology and non-technology growth companies is calculated for each
of the past six years. The five-year growth rate in tech earnings, averaging
42% between 1995 and 2000, is significantly faster than that of non-tech
growth companies, which averaged only 17% during the same time period.
Thus, other things being equal, tech stocks should command a higher
P/E than non-tech growth stocks.
But other things are not equal. Between 1995 and 2000, the weighted
average five-year earnings volatility for technology companies is about
50% higher than the earnings volatility for non-tech growth companies,
although the gap seems to be narrowing over time. Taken together, the
supranormal growth in tech earnings is associated with higher risk, as
we have been painfully witnessing in the current downturn.
Thus, relative to the S&P 500 and non-tech growth stocks, the current
level of tech stock prices do not seem to be out of line. However, on
an absolute basis, the current P/E ratios for the S&P 500, the techs,
and the non-tech growth companies are all still quite high compared to
the historical averages. So, the more important question is: Does the
valuation of the market as a whole look reasonable?
To answer this question, Figure 3 depicts
the S&P 500 earnings-price ratio (E/P) and the real AAA-rated corporate
bond yield. The E/P ratio is simply the inverse of the P/E ratio, and
it measures the earnings yield from holding stocks; the benchmark for
comparison in this case is the inflation-adjusted yield from holding high-grade
corporate bonds. Before 1997, the S&P 500 earnings yield had almost
always been higher than the real corporate bond yield, on average by 160
basis points over this period. This reflects the risk premium from holding
stocks over bonds. However, since 1998, the run-up in stock prices pushed
the earnings yield well below the real AAA bond yield, suggesting that
there was a risk discount rather than a risk premium for
holding stocks. Currently, the earnings yield and the bond yield are about
the same. One may argue that with corporate earnings growing so fast and
the inflation rate so low, the equity risk premium ought to come down—but
it's still somewhat difficult to imagine that it will come all the way
down to zero. Hence, to justify the current valuation, corporate profits
must be able to grow at a fairly rapid rate in the future, which remains
the biggest uncertainty given current economic conditions.
This Economic Letter began with two questions. First, what happened
to the NASDAQ? The sharp rise and fall of the NASDAQ composite has been
mainly a tech phenomenon. The rapid ascent in tech stock prices was fueled
by "exuberant" growth expectations. As the vastly inflated expectations
ultimately could not be met, tech stock prices plummeted.
The second question was: Do current stock price valuations make sense?
At the current level, tech stock prices do not look unreasonable, relative
to the broad stock market and in particular to non-tech growth stocks.
However, in terms of the broad stock market, it is somewhat difficult
to judge whether future earnings growth will be fast enough to justify
the current valuation.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
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