I'm getting the feeling that we're reliving the '70s again. Maybe disco and bell-bottoms haven't come back in style, but the economy is stagnating, unemployment refuses to go down, oil prices remain high … and the stock market seems to be producing a new version of the Nifty 50. And like the original Nifty 50, it might be just a matter of time before the stocks in the new version suffer a hard landing.
For those wondering, the Nifty 50 was a group of blue-chip, large-cap American stocks that strongly outperformed the broader market in the late 1960s and early 1970s. While American equities at-large moved sideways for much of this era, the Nifty 50 continued to shoot higher, as investors saw them as safe havens they could rely on to deliver earnings growth in the face of economic turmoil. The result was that these companies, which included familiar names such as IBM, Coca-Cola, and McDonald's (as well as some less familiar names such as Lubrizol and Simplicity Pattern), found themselves carrying oversized valuations relative to their peers. P/E ratios above 40 weren't hard to find.
None of this bothered investors, as long as the Nifty 50 stocks could maintain their reputation as unblemished growth stories. But when the recession of 1973 arrived and Wall Street decided that its growth expectations for the Nifty 50 were too optimistic, things got ugly very quickly. The shares of many popular names fell by 70% or more in less than 18 months, and the names that did eventually recover needed more than a decade to do so.
Fast-forward to 2010, and we have a different type of Nifty 50 forming. This time around, most of the richly valued, outperforming names aren't blue-chip large caps but rapidly growing tech companies such as VMware
As with the Nifty 50 near its peak, the new breed of market outperformers features plenty of names trading at jaw-dropping multiples. VMware sports an enterprise value (market cap minus net cash and investments) that's 47 times its estimated 2011 earnings. Netflix trades at an enterprise value that's 44 times its 2011 estimates. How about salesforce.com? Try 69 times its estimated earnings for its fiscal year ending in January 2012. And Amazon? I guess you could say it's a relative bargain, since its enterprise value is a "mere" 40 times its estimated 2011 earnings.
Perhaps some of these valuations would look a little better if based on future free cash flow rather than on earnings -- salesforce.com, for example, routinely sees quarterly free cash flow that's higher than its quarterly earnings, because of the way it recognizes revenue for subscription payments. But no matter how you cut it, valuations for certain tech stocks have spun out of control. And oddly enough, this speculative frenzy comes at a time when valuations for many prominent tech stocks are still quite reasonable.
Instead, it's a lot more like 1972, when investors decided that the only way to make money in a shaky economic environment was to keep riding a handful of growth stocks, no matter how lofty their valuations became. Cisco and Intel can't grow much in a weak economy? No problem. Just keep putting money into Netflix and VMware. Those companies have plenty of growth ahead of them, don't they?
Well, it sure looks that way right now. But if a worsening economy -- or just some factor specific to the company in question -- derails that growth, then look out below. That's the lesson we should learn from the crash of the original Nifty 50. When a group of stocks is priced to perfection, any sign of imperfections will have those stocks taking it on the chin much worse than stocks with more subdued valuations will. We might have seen a good example in action earlier in the week, when shares of Green Mountain Coffee plummeted by nearly 20% after it was disclosed that the SEC asked for additional information about its revenue-recognition practices.
Considering that the SEC has hasn't yet levied any formal charges at Green Mountain, and that the revenues in question amount to only a small percentage of the company's sales, you wouldn't expect its shares to get hit so hard. But with Green Mountain trading at such a lofty valuation entering this week, a little bad news proved capable of doing serious damage. And if the economy proves to be a little weaker over the next year or two than Wall Street expects it to be, I think that's a story that will repeat itself with many other names in the market's new Nifty 50.