Thursday, September 18, 2014

Why Late 90s Euphoria Is Not Coming Back

A recurring meme in the stock market is that retail investors today are not as enamored with equities as they were in the late 1990s. The softly spoken corollary is that until we see that level of euphoria, stocks will continue to rise unabated.

If you missed the 1990s, here are two personal anecdotes to describe what it was like:

1. Online trading services like E-Trade were brand new. Our firm was hired to advise one such company in 1998. During the course of several focus groups, former policemen and teachers described how they had left their jobs to day trade. But it wasn't just their own capital; they were also trading the savings and retirement accounts of their neighbors and family members.

2. In late 1999, we sat down with the CEO of mid-sized technology firm in Silicon Valley. As the meeting started, the CEO bought stock. Two hours later, he sold for more than a million dollar gain. The next week he used that money to pay 30% over the ask for a $4 million property in Atherton. He razed the nearly new house on the lot three months later.

Imagine this: the Nasdaq nearly tripled between 1996 and 1998. Then, in the next 18 months, it quadrupled. How do you think that impacted investor psychology?

That was the investment climate attracting former policemen and teachers to day trading. In comparison, the market's 60% rise since the start of 2013 seems rather drab.

There was a legendary IPO frenzy in the late 90s. went public in November 1998 at a price of $9. On the first day, it traded up to $97. Side note: by 2000, it was trading at 10 cents.

VA Linux gained 700% on its first day of trading in December 1999. The company was valued at $9 billion. The year before, Linux had $5 million in sales and earned a total of $84,000 in profits.

By 2000, a ten year old internet company named America Online had become so generously valued that it was able to buy the 80 year old media giant Time Warner for $160 billion.

In the prior 120 years, company valuations had never exceeded 30x earnings (CAPE). In 2000, valuations were a full 50% higher than this prior peak. Valuations based on sales and balance sheets tell a similar tale.

The thirst for equities was driven in large part by the excitement over new technology, but that is only part of the story. There were very strong fundamental winds behind the stock market. Europe had become unified. China, India and other emerging markets became dynamic, fast growing entrants into the world economy. During this period, the Hang Seng increased six-fold in seven years. There was global optimism.

That is quite different from today. China is slowing and Europe is mired in a no-growth environment bordering on deflation.  The highly touted single currency is increasingly viewed as an albatross.

The same is true in the US. Real GDP growth in the 1990s was 5%, and the rate accelerated as the decade wore on. There had not been a period with sustained high growth like this since the early 1960s.  Despite all time highs in equities, economic growth today is less than half that rate (chart from JPM).

In the US, real median incomes grew 19% between 1984 and their peak in 1999. Investors at that time were, rightly, feeling that the stock market accurately reflected their financial circumstances. Since then, they have fallen 9%. The drop has been most pronounced for the bottom 60%; incomes for the top 40% did not peak until 7 years later and their decline since then has been half that of lower income households (chart from Doug Short).

By the late 1990s, the proportion of the population that was employed reached an all time high. That included both an increasing proportion of women in the workplace as well as a high level of employment for the largest demographic group of the post-war era, baby boomers. High employment and growing wealth fed into the euphoria for stocks. Employment ratios have fallen ever since, leaving a sense today that the economy and the stock market are disconnected.

All told, it's not hard to see why the same level of euphoria is not present today as it was in the late 90s. Regaining prior levels of growth, income and employment will likely be far in the future.

Moreover, its probably fair to say that the combination of political and demographic events, in both the US and abroad, make the late 90s unique. As a yardstick for what constitutes investor enthusiasm, it's probably not very useful.

So the psychology of the market feels very different than in the 90s. That is not to say that investors are currently unenthusiastic towards equities.

Forget about sentiment surveys. Using data from the Fed, US household ownership of stocks was 35% of their financial assets at the end of June. To put that in perspective, since 1945, it has only been higher in 1999 and part of 2000. Investors may not be managing their neighbors IRAs but their ownership of stocks has rarely been higher.

Their use of debt to fund share purchases exceeds that of 2000 on both a dollar basis and, more importantly, as a proportion of market capitalization. Yes, margin debt might increase further but its hard to argue investors have not yet embraced the equity culture.

The IPO market is nothing like the 1990s, but the market for private companies is very hot. High valuations have moved from the public equity to the private equity market. Why? Because the public market is hot enough to absorb these highly valued and relatively unprofitable companies when they want to IPO at even higher valuations. This wave of IPOs will be coming to the stock market before long.

Investors will wait in vain for the return of 1990s euphoria. It did not come at the end of the 2002-07 bull market and it was never present in the many bull markets since the 1920s. It was the product of a unique combination of political, economic and demographic factors that are unlikely to combine again in most investors' lifetimes.

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