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U.S. Equities Are More Dangerous Today Than The Dotcom Bubble

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The dot-com bubble has ended. 

This end came with one of the sharpest selloffs in a major index of all time.

The following chart demonstrates the NASDAQ composite lifecycle from its March 2010 intraday high to its low 30 months later:

Looking back, the era of dot com was the perfect example of a bubble. 

These years saw growing optimism, high valuations, and extrapolated growth rates for years on companies without making sales.

Surprisingly, the second-longest bull market does not show the same bubble signs. 

However, it did see a growth recession for four quarters straight for the S&P 500 index. 

This resulted in narrow profit margins and valuations that continuously escalated across the board.

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The combination of the two is making people anxious over the next bear market and whether or not it is going to be closer than with what they are comfortable. 

The S&P 500’s price-to-earnings ratio (or P/E ratio) on June 17, 2016, was 23.85. 

When you compare the valuations of the last two bear markets with those that came before it, the number on June 17 was lower than the P/E ratio that was seen in 2000, and higher than the one in 2007.

Markets have the potential to keep expensive valuations for an extended period. 

The truth is that the current bull market coming to end might be more hazardous for investors than what happened in the aftermath of the dot-com bubble.

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Investors Shunned Tech

The dot com bubble was a tech-heavy NASDAQ Composite.

While it somewhat lifted all boats, it also bore the full impact of falling equity prices when investors began to steer clear of technology companies. 

At the time, the NASDAQ had the following losses, a descent that resulted in a total loss of 78% over a 30-month period.

  • 8% in 2000
  • 7% in 2001
  • 6% in 2002

At the same time, the Dow Jones Industrial Average was being called a dinosaur because it lacked the tech exposure and the NASDAQ was feeling its highs.

The Dow Jones Industrial average saw the following drops:

  • 18% in 2000
  • 1% in 2001
  • 76% in 2002

Up or Down?

The low yields found in the bond market have played a significant role in causing investors to push stock valuations higher across the board. 

This includes utilities, consumer staples, and other defensive sectors. 

In the following chart, XLU is an ETF, or exchange traded fund, which is made up of 29 different utilities listed within the S&P 500 known as the Utilities Select Sector Fund. 

XLP is the Consumer Staples Select Sector Fund, which contains a portfolio made up of 36 consumer stocks that are non-cyclical.

As you can see in the above chart, both sectors are vulnerable to a sharp pullback if a market drawdown occurs due to their high valuations.

Low-volatility stocks have also seen their valuations be pushed higher since the year 2014. 

This has been because of smart beta funds that are made up of companies with betas that are lower-than-market increasing in popularity.

The following list is an example of this:

iShares Edge MSCI Minimum Volatility USA ETF

  • $4.7 billion made them have the second highest YTD inflows of any ETF through April 30th of this year.
  • P/E Ratio for the fund is 25.53
  • This is significantly higher than average

As a direct result of the above list, more volatility may be seen in reaction to a sustained drawdown than what is historically considered normal.

Rays of Sunshine, Please?

In March 2000, the NASDAQ fell from its highs. 

When it did, investors moved on over to the bond market. 

Over at the bond market, over 6% was being paid for ten-year Treasury notes.

May to August saw a brief recovery rally take place. 

After this recovery period, the market went into a sort of freefall due to the escalation of demand for ten-year notes. 

Then the end of the year came.

By the time the end of the year arrived, the yield for a ten-year note had dropped all the way to 5.12%. 

This factored into the total return for the year at 16.66%.

Demands for bonds by investors were still high through the entire recession. 

In the end, an average ten-year note saw a total return from 2000 all the way through 2002 of 12.45%

In English, Please?

The dotcom bubble came with more optimism than the current bull market has. 

However, if the market is unable to hold it current move upward, it could come with costs.

When the dot-com bubble deflated, investors moved from technology and went over to enjoy the safety of investing in defensive stocks and treasuries. 

Investors may begin to seek an alternative haven once again, but have nowhere to go, if this bull market ends up changes direction.

Investors will start finding safe places due to the escalation of valuations within low-volatility and defensive stocks together with low-interest rates history has shown us is sure to follow.

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