Nasdaq record reflects markets stuck in time warp

This week has been like living in a time warp. On Thursday, the Nasdaq Composite hit a new high for the first time in 15 years. That event came a good decade earlier than I and many others had expected.

Then, on Friday, Amazon announced a loss and the market pushed up its share price by 15 per cent to a record, increasing the fortune of its founder Jeff Bezos by about $5bn in the process. I had thought the crazy logic that losses were good, because they showed that companies were still investing in growth, had died when the Nasdaq bubble popped 15 years ago: I was wrong.

In another echo of the past, Japan's Nikkei 225 passed the 20,000 level, also for the first time in 15 years. And in Europe, the debate is over whether Greece will default, whether it will leave the euro and whether such an event could have the same effect as the 2008 Lehman bankruptcy. All of those topics have been on the agenda for at least five years and are still unresolved.

Rounding off the Groundhog Day theme, the wider US stock markets - not just the Nasdaq - managed to set yet another new high. Earnings estimates have been slashed, anxiety over the plans for interest rate rises by the Federal Reserve (whose Open Market Committee meets next week), remain intense, and many bullish commentators have been braced for a healthy correction. And yet, as has been the story for six years now, US stocks keep grinding higher, like the Energizer bunny.

All this despite valuations that look terribly stretched. The S&P 500 now trades at a multiple of 27 times average earnings for the past 10 years. That is its highest since the peak of 44 at the top of the Nasdaq bubble. The only other time it has been this high was immediately before the Great Crash of 1929.

How to explain all this? Earnings have generally beaten their reduced expectations, so this has helped. However, the argument does not go far. According to Thomson Reuters, forecasts are still for an outright fall of 1.1 per cent in S&P earnings for the first quarter. Energy and industrial companies are reporting worse numbers than expected.

More usefully, the dollar's strength is abating at last. On a trade-weighted basis, the dollar has fallen below its 50-day moving average, a measure of the short-term trend, for the first time since last July. This is a sensible reaction to the weakening economic data, and helps US stocks. Bond yields are also lowering, reflecting the belief that the Fed will not be raising rates until the autumn at the earliest. So the contorted logic of the past six years stays in place. Stocks are expensive but while rates stay low, and earnings avoid a serious collapse, money flows into them. A strong catalyst - really bad earnings, a bad geopolitical event, or a surprise from the Fed - is needed before the market can jolt out of its steady ascent.

And in any case, valuation has nothing to do with short-term market moves. A report from Barclays this week pointed out that since 1988, US stocks have never fallen over the subsequent year when they have been valued at 17 times next year's expected earnings, as they are now. But this does not mean that stocks are cheap. Barclays' data also show that there were plenty of instances of stocks falling in the year after they were valued at forward earnings multiples of between 11 and 15 - and also at multiples of 19 and more.

For the longer term, remember the Nasdaq bubble only burst in 2000 after it had become the most extreme speculative mania ever. Stocks had been more expensive than they are now for more than two years before it finally peaked. Stocks can stay overvalued.

Nasdaq's 15-year recovery has been swift. It took 25 years for US stocks to recover after 1929 and, even with the Nikkei's recent strength, Japanese stocks are still barely half the level of their peak in 1989. That recovery is in turn attributable chiefly to remarkable growth in earnings and revenues by a number of companies, led by Apple.

But, outside Apple, the Nasdaq stocks of 2000 would have been a horrible investment. The best stocks then, it turns out, were totally out of favour. The five stocks in the S&P that went on to be "ten-baggers," rising tenfold in the 15 years that the Nasdaq was flat, include Ball Corporation, which makes cans, CSX, a railroad, VF Corporation, which makes jeans - and Apple, which seemed to have been defeated by Microsoft.

So let me summarise a couple of lessons from the last decade and a half. First, valuation tells you almost nothing about short-term timing; stocks can stay too expensive for a while. But second, in the long term, buying a security that is blatantly too expensive is going to hurt. Just ask all those Nasdaq investors who are only just back into the black.

For those with the patience to wait, and do the work of analysing obscure companies, there is more money to be made from contrarian positions in out-of-favour stocks. I do not know where today's Ball Corporation or VF are, but they are out there somewhere.

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