Dow 17,000: I Am Not Exactly Celebrating

Aggressive Federal Reserve easing and low interest rates may have fueled a bubble in Web 2.0 stock. A diversified portfolio can help counter immediate financial risks, while still allowing for steady long-term growth.

Jul 22, 2014 at 2:17PM

On July 3, 2014, the Dow Jones Industrial Average established an all-time intraday high of 17,074. The date was a capstone to a quiet, yet powerful stock market move from the depths of the 2008 housing bust and credit crisis. This latest run-up in share prices, however, may have actually occurred amid a period of economic contraction. A recently revised report out of the U.S. Commerce Department indicated a 2.9% annual decline in gross domestic product through the first calendar quarter of 2014.

Main Street savers should come to terms with the fact that Wall Street valuations have far outpaced underlying economic realities. For now, long-term investors may work to build out a diversified portfolio, in order to guard against severe losses, while still allowing for real growth. Historically accommodative Federal Reserve monetary policy has driven speculative capital toward a Web 2.0 bubble that will likely burst. As such, the broader market remains at risk for contagion.


The Federal Reserve Board
The Federal Reserve is tasked with the somewhat contradictory dual mandate of managing the economy toward both maximum employment and stable prices. To do so, the Federal Reserve can trade government securities through open market transactions and impose particular reserve requirements upon member banks that do business within the United States. The Federal Reserve typically targets lower interest rates amid recession, in order to encourage private individuals and institutions to take out loans, purchase investments, and commit to capital spending. From there, Fed officials often drive rates higher through economic recovery, in order to guard against inflationary risks.

In Q4 2008, the Federal Reserve Board lowered its federal funds rate to an unprecedented zero, amid the housing bust and credit crisis. The U.S. Treasury and Federal Reserve also coordinated plans to install the Troubled Asset Relief Program, Operation Twist, and Term Asset-Backed Securities Loan Facility credit crisis responses within financial markets. The Fed has only recently begun to taper its additional commitment to purchase $45 billion in longer-term Treasury securities each month. In all, the Federal Reserve balance sheet swelled to $4.4 trillion by July 9, 2014.

Taken in concert, the aggressive Federal Reserve and Treasury programs have worked to keep prevailing interest rates at historic lows. For now, one-month Treasury Bills and three-year Treasury Notes yield 0.01% and 1%, respectively. Further along the yield curve, the Treasury is offering a mere 3.5% in annual yield to investors who agree to lend money to the Federal Government for 30 years. Also, the Bureau of Labor Statistics' Consumer Price Index measure of inflation has increased by 2.1% over the past 12 months. As such, fixed income investments are offering all but nil, in terms of real returns. In response, legions of investors have built out portfolios that take on extraordinary financial risks.

The Web 2.0 bubble
The Web 2.0 revolution has added social media to the original dot-com infrastructure. Web 2.0 engineers and executives operate as broker-dealers who match third-party advertisements to an established user base. The more sophisticated technical outfits sell goods and services directly to their website visitors. As a starting point, the Web 2.0 business model begins with generating traffic. Web 2.0 businesses, however, will ultimately fail, if site traffic cannot be efficiently monetized.

Critical Web 2.0 junctions would include Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), and Pandora (NYSE:P). As a group, the Web 2.0 stocks are notable for outrageous price-to-earnings multiples that could sabotage real returns. The term Web 2.0 may therefore define a class of intriguing businesses that are too expensive to consider owning as stocks. Pandora is now worth $5.4 billion, in terms of market capitalization, although the Internet radio company has yet to turn annual profits as a publicly traded company. To date, Pandora shareholders have dealt with the maddening Catch-22 of the company paying out higher proportions of revenue as royalties, at the same time that the radio streaming service has gained in popularity.

The National Retail Federation recently ranked Amazon as the ninth-largest American retailer, with $44 billion in 2013 U.S. retail sales. In all, Amazon closed out its 2013 fiscal year, which also coincided with calendar time, having generated $74.5 billion in revenue. Of this amount, only $274 million trickled down to the bottom line as net income. Amazon gives product away at or near cost, in order to drive traffic toward various online destinations. Amazon stock trades for nearly 600 times trailing earnings.

Technology bulls, of course, may argue that a steep price-to-earnings ratio is the price to pay, in exchange for holding the stock of a rapidly growing concern. Amazon, however, is coming off a 2012 year of $62 billion in revenue and $39 million in losses. For 2010, Amazon posted $1.2 billion in net income and $34.2 billion in revenue. Quite frankly, Amazon is not growing nearly fast enough to justify its aforementioned stock market valuations. For now, let Amazon serve as the corporate poster child representing the Web 2.0 bubble.

The bottom line
Conservative investors should consider selling Web 2.0 stocks that haven't turned a profit or trade for earnings multiples above 50. Legendary investor Peter Lynch often targeted stocks maintaining price-to-earnings-to-growth ratios of less than one as being suitable investments. According to Lynch's metric, Facebook, with a P/E ratio approaching 90, would be significantly overvalued. For Facebook, or any Web 2.0 company, 50% annual net income growth is not a realistic expectation over the long term. The Web 2.0 revolution, in the aggregate, may be described as the second coming of former Fed Chairman Alan Greenspan's "irrational exuberance," which was also fueled by cheap money. 

Web 2.0 stocks are priced for perfection. As such, any Web 2.0 revenue and earnings miss will likely lead to severe losses in share price. 

A diversified portfolio may help conservative investors to mitigate downside risks, while also allowing for growth potential. Within the tech sector, shares of Apple are trading for relatively reasonable earnings multiples. For its part, Apple closed out its Q2 2014 books with $150.6 billion in cash and investments on the balance sheet. Of this amount, Apple has pledged to return $130 billion back to investors through buybacks and dividends, by the end of calendar 2015. Apple's aggressive capital return program effectively builds in a put, or price floor in shares.

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Kofi Bofah is long Apple. The Motley Fool recommends, Apple, Facebook, and Pandora Media. The Motley Fool owns shares of, Apple, Facebook, and Pandora Media. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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