Thursday's stock market drop was a reminder to investors that nothing about 2020 is going to be easy.
Though plenty of tech investors have reaped the rewards from the stock price surge since March, the Nasdaq's 5% sell-off on no news on Thursday showed that those gains could be easily washed away. This is a bull market built on sand, with an economy still stuck in the coronavirus pandemic, an unemployment rate that only just recently fell just below double digits, and a number of industries in crisis mode.
Nonetheless, the S&P 500, led by the tech sector, has surged to all-time highs. And blockbuster gains in the FAAMNG group as well as popular names like Tesla (TSLA 2.48%) and cloud stocks like Zoom Video Communications (ZM 3.01%) have led to a fervor among investors who have seen returns on individual stocks of 100%, 200%, or even better in recent months.
The movement is complete with its own band of cheerleaders, led by Barstool Sports founder Dave Portnoy, who's trash-talked investing legend Warren Buffett and chants, "Stocks only go up." It has inspired some comparisons to the dot-com era when the Nasdaq gained more than 400% between 1995 and 2000, and doubled in roughly the last six months of the rally, with a number of stocks jumping by 20 times or more. Then the tech-focused index plunged 78% between 2000 and 2002.
With the Nasdaq jumping 82% from its trough in March to its peak earlier this week, in the midst of an economic crisis, another bubble seems to be forming. Should investors fear another dot-com crash? Let's look at two ways the current market is similar to the dot-com era, and one big reason it isn't.
Retail investors are pouring in
The dot-com era was famous for bringing in a new wave of retail investors who took advantage of novel online trading platforms like E*Trade to jump on the tech-stock bandwagon. This time around, the attraction of tech stocks has led to another boom in retail investing, aided by the popular trading app Robinhood, which has again democratized trading by making commission-free trades the norm in the industry.
Americans, some of whom have extra time on their hands during the pandemic and limited ways of spending money, have turned to trading as a way of making some extra cash during the pandemic. There's even evidence that sports bettors have turned to stock trading to get their gambling fix with professional sports essentially canceled for months during the crisis.
According to The Wall Street Journal, the number of positions that Robinhood investors hold in S&P 500 stocks jumped from less than 5 million in February to more than 14 million in June. Log-ins to other trading accounts have also spiked, and net E*Trade account additions, which averaged 15,411 over the previous 15 months, jumped more than 260,000 in March, and have remained elevated since.
Retail investors are considered to be less sophisticated and more momentum-driven than professional and institutional investors, and the surge in interest from individual traders has likely inflated the tech stock recovery, though there's no good way of measuring their impact.
Valuations are getting stretched
During the dot-com era, the Nasdaq Composite's price-to-earnings valuation ran up as high as 200. By comparison, the index's P/E today is a relatively tame 28, only modestly higher from 23 at the end of the year. However, in many of the stocks that have driven the rally, valuations have escaped their historical bounds.
Apple's (AAPL 1.98%) P/E briefly topped 40, the highest it's been since 2008, shortly after the iPhone was introduced. In other words, investors think that (all other things being equal) the company's growth prospects are better now than at any point in the last decade. Considering that the company is already valued at more than $2 trillion and management's favorite profit growth tactic -- buying back shares -- has been neutralized by the stock's surge, that seems unlikely.
Tesla is a tricky company to measure according to traditional metrics, but the stock's run-up of as much as 1,000% over the past year seems difficult to justify based on fundamentals. While the company's prospects and results have clearly improved over the last year, it seems dubious that it deserves to be the seventh-most-valuable American company with a market cap over $400 billion, which it was until the recent sell-off.
Stock splits at Tesla and Apple, another sign of a bubble, helped fuel their recent rallies, though both stocks have fallen since the splits.
Meanwhile, stocks like Alphabet (GOOG 0.53%) (GOOGL 0.36%) and Facebook (META 2.33%) have taken off, reaching record highs, even as profits have fallen due to cutbacks on digital ad spending.
One reason to believe in the rally
While it's true that valuations in a number of tech stocks have gotten inflated, many tech companies are seeing real tailwinds from the pandemic, and their growth has been underpinned by clear improvements in their fundamentals. Amazon posted 40% revenue growth in its second quarter and its quarterly profits shattered the company's previous records as well as its own guidance.
E-commerce stocks, including Amazon, have been major beneficiaries of the pandemic. Zoom Video, likely one of the biggest winners during the crisis, saw revenue more than quadruple in its second quarter, along with a huge profit, as its videoconferencing platform has gone from a niche business product to a household name and a necessary utility, embraced by millions of Americans working and learning from home. Similarly, other work-from-home stocks have seen a surge in business as well.
By contrast, during the dot-com era, investors focused on growth above all else and lost sight of the bottom line, bidding up stocks based on metrics like ad impressions, even though many had fundamentally broken business models. With investor money flowing freely, tech start-ups spent aggressively to drive growth, which led to the bubble bursting when growth slowed and profits never materialized.
Tech stocks today, by contrast, include some of the biggest companies in the world, such as the FAAMNG group, as well as some popular cloud-computing plays, a sector that's been shown to be a successful and profitable business model at scale. The industry has grown up since the dot-com era, and the companies that make up the Nasdaq today are much different than they were 20 years ago.
What's an investor to do?
Considering the underlying strength of companies like the FAAMNG group, we're unlikely to see a crash on the order of the dot-com bust. But the economy is still fragile, especially after the $600-a-week federal unemployment boost expired at the end of July. And hiring in software development is still down by about one-third, according to online job board Indeed, a sign that tech companies are taking a cautious tack.
While there is a serious risk of a pullback in stocks, especially in the tech sector after the recent run-up, no one knows what's going to happen in the near term. The economic recovery could stall out, or it could pick up speed, especially if a vaccine is approved sooner than expected.
The best thing for investors to do is to stay invested and own high-quality stocks, especially those with competitive advantages that offer tremendous growth potential or reliable profits at a reasonable valuation.
Even if tech stocks do crash, over the long-run history has shown that they'll recover and climb to greater heights. While you would have hated to buy into the dot-com boom just as it was peaking, even if you had invested in the Nasdaq at the peak of the mania in 2000, you would still have more than doubled your investment today.