Lessons Of History
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Two weeks ago, we compared the current Nasdaq bear market to the Great Bear of 1929-1932, but a more relevant comparison could be the 1973-1974 bear market.
Then, as now, the market was led by a collection of pricey stocks dubbed the "Nifty Fifty." And 1973-1974 was also the worst Nasdaq bear market until the current one came along, with a 60% plunge surpassed only by the Nasdaq's 68% drop of 2000-2001.
Jeremy Siegel, a professor at the Wharton School and author of Stocks for the Long Run, studied the original Nifty Fifty stocks of the early 1970s, the "one-decision" stocks that investors were told they could buy and hold forever. What he found is something every investor should know.
At their peak in December 1972, the Nifty Fifty traded at a price-to-earnings ratio (PE) of 40, more than twice that of the rest of the S&P at the time. The Nifty Fifty were devastated in the 45% bear market of 1973-1974, losing most of their value in the carnage.
But at least on one level, the view that these stocks were worth twice as much as the rest of the market turned out to be true: from their peak, the Nifty Fifty as a whole matched the performance of the S&P 500 over the next 25 years.
But if investing were about paying up for top names just to match the performance of the S&P, you'd probably sleep better putting your money to work in an S&P 500 index fund and forgetting about it. As 1973-1974 and 2000-2001 show, high PE stocks get hit much harder in economic downturns. Volatility probably drives investors out of the market more than anything else.
What is most interesting is what Siegel found when he looked under the hood of the Nifty Fifty: the Nifty Fifty stocks with PEs over 30 tended to underperform the S&P over the next 25 years, while those with PEs under 30 generally outperformed the market. Even with the best of the best, valuation - and diversification - matter.
The Nifty Fifty's consumer stocks and pharmaceuticals (Coca-Cola, Philip Morris, Procter & Gamble, Merck and Pfizer) tended to outperform the market over the following 25 years. And every technology stock in the Nifty Fifty (IBM, Xerox, Unisys, Digital Equipment, Polaroid and Kodak) underperformed the S&P in subsequent decades.
However, the tech stocks all fell into the high PE category (Polaroid traded at more than 90 times earnings at its peak), while the consumers and drugs tended to be lower PE stocks, so at least some of the subsequent performance was due to valuation. Most investors don't understand technology, so they bid tech stocks to irrational peaks when times are good, giving the stocks much more room to fall when the economy sours. Investors either love tech stocks or they hate and fear them; they never approach them rationally, as they would a soup company.
But the underperformance of the Nifty Fifty tech stocks also says something about the nature of technology companies in general. There is no other explanation for why stocks such as Xerox and Polaroid, which held such commanding market presence in the early 1970s, have produced flat to negative returns since then.
Most technology companies become slaves to their own technology or standards. They build products at least in part so they are compatible with the previous generation of their products. Cisco's need to build routers that were compatible with previous models left the door open for Juniper Networks to start with a clean slate and no preconceptions. Rare is the technology company that can reinvent itself to stay on top for more than a few years at a time. IBM has successfully reinvented itself several times, but has produced some mighty lean years in between.
It also helps explain why major bear markets tend to be seminal events, leading to significant changes in market leadership. The tech stocks that led the market in the 1990s may not lead in the 2000s. The Oracles, Sun Microsystems and Ciscos may not be the next technology leaders, and their early struggles could be an indication of shifting market leadership. Buying Xerox in the early 1970s would have cost you severely since then, but buying Intel would have made you wealthy. The challenge for tech investors is to spot those emerging leaders. Watch for breakouts and accelerating fundamentals, and ignore laggards.