Ned Davis Research Fearing Another Tech Bubble

Tech Bubble

The huge bear market that hit stocks in 2000 is generally referred to as the tech bubble bursting, and some people are now in fear of the sky falling now in a similar fashion.

With all the talk out there these days about the stock market allegedly moving toward another possible tech bubble bursting, we certainly don’t want to be swallowing this whole like people generally do with these things, especially views that turn out to be nonsense.

If your understanding of stocks is woefully misguided, if you think that the ratio of present to future valuations is a danger sign, it’s not hard at all to then take this confused view and use it to see all sorts of monsters that aren’t there, especially the big one, the bubble bursting monster.

A big bubble did indeed burst in 2000, and if you understand stock prices in terms of price to current earnings, and you see that this ratio is back in the neighborhood of where it was back then, it’s understandable that you may think that we might see something like this again, that today’s bubble may burst soon.

There is something curiously missing this time though, an actual bubble or anything remotely resembling it, but you need to know what a real bubble looks like. No matter though, we can just throw the idea of a bubble out there, defined as a certain price to earnings ratio, and if a bubble can be imagined, it’s just one small step to then imagine it ready to burst.

It is not that bubbles don’t exist or that they aren’t real when they do appear, but we do owe it to ourselves to stick to the real ones. In order to do that, we need to know what a bubble is, and why they burst.

We do have the king of bubbles to use as a reference, and luckily, we don’t have to go back many decades when stock trading was in a far less evolved time to see it. The king bubble only 20 years back, during the modern era with market participation as broad as it was then and during the time where technology has transformed stock trading so massively, although it wouldn’t really matter that much if this were ancient history, as bubbles are bubbles and huge ones can burst regardless, whether they are with stocks, digital money, or tulips.

Those of us who were actively in the market during those days will remember how massively heady the late 1990’s was, which produced a move to the upside for the ages, one far in excess of anything we’ve ever seen before or will probably ever see again. This was a bubble, in no uncertain terms, but we need to understand why it was, and what a bubble actually is, before we start comparing anything to that event.

The fact that anyone would compare today’s markets to the bubble of 2000 clearly demonstrates that they have no clue what a stock market bubble really is, and especially no idea of why they burst. Without this understanding, it’s not surprising that people will see monsters under the bed because that’s what happens when you rely solely on your imagination to perceive reality, as if you have conjured up the bubble, it’s pretty easy to also conjure up its bursting.

Ned Davis of Ned Davis Research has had this bad dream, although he’s far from alone. This is not even the prevailing view, visions of bubbles and their bursting in any way akin to 2000, a real collapse, but the concern itself about a bursting of a notable amount is very widely held these days, and we don’t want to allow any degree of misperception to guide us.

The crux of the mistake being made by Davis and others is their believing in the fairy tale of present earnings being meaningful to stock prices. If you think that they are meaningful at all, you commit this mistake, and if you believe that this is the only real thing that matters to stock prices, you are completely lost because stock prices actually have nothing to do with these things as it turns out.

People don’t buy stocks to see the companies earn, they want to earn themselves, by riding waves up. They don’t sell them because they feel bad for the companies that aren’t growing these earnings fast enough, they just don’t want to lose money themselves on the deal.

The ratio of price to current earnings isn’t the only driver of stock prices, it isn’t the main driver, it isn’t a significant driver, it isn’t even a modest influencer, it’s not even that this is irrelevant and meaningless, of no effect, it’s even worse than that.

Even when better earnings and higher prices go together, or lower earnings and lower stock prices happen at the same time, people are buying and selling not by looking at earnings but by looking at the stock prices move. When prices crash, they aren’t even looking at the earnings, they are just joining the stampede to save from being knocked down and stepped on. This should be so obvious, but only if you have set aside your illusions and dare to look around a bit, and think a bit.

It is this ratio continuing to climb, especially with tech stocks, that has Davis and others seeing this monster materializing now, where ratios have indeed climbed up to what is perceived as the thinner air of the late 1990’s, when their balloon did get blown up so much and so fast that it did end up bursting.

The first thing we need to understand if we’re to get our head around why thinking that this is going on now is so misguided is what these ratios actually tell us, what they actually represent. The difference between a privately held stock and a publicly traded one is that private shares aren’t traded and therefore are valued primarily on what a company is worth now, where publicly traded shares speculate a lot more on the future value of the stock.

The market will value stocks in the future differently, depending on the future potential that they see for the stock, and it’s actually important to point out that the future perceived value of a stock isn’t quite the same thing as the potential for the company itself, even though they are related.

To clarify the difference, people bid up Bitcoin by a huge amount and there is no company or anything that corresponds in the physical ream involved, and this is where they are valuing the future value of the security in a pure form. As people value this higher, this affects the expectation of the future value of a stock independently and in addition to any future business valuation they may hold.

Those stocks that the market has a higher future valuation with will see this represented by a higher ratio of price to current earnings, although the current earnings in this equation is the reference, where the higher the ratio, the brighter the future is seen to be, and the brighter the future turns out to be as well generally.

The Higher Valuations of Today Indicate Health, not Illness

The conventional approach to this ratio actually looks to be put off by stocks that have a brighter future and prefer stocks with a dimmer one, ones that aren’t expected to do so well down the road. This is why we explain this as preferring the bad and avoiding the good.

This approach ends up being unspeakably foolish, but as long as we do not speak about it too much, the myth just lives on. We call using this formula “valuation,” even though it actually is a complete bastardization of the concept of valuation, even to the point of inverting the truth completely.

Sure, this ratio was higher during the 2000 bubble, and it’s back up in that range now, but we blew up our balloon much more slowly this time, and that part matters a great deal.

We’re not even sure how earnings got crowned king in of the world of trying to understand stocks in the first place, whether this be past, present, or even future earnings. Investors do like earnings going up, although there is no objective link at all between earnings and stock prices, nor is there any objective links to stock prices at all. When we think that there is, this is where we become lost, when we believe that an objective standard will somehow control or modify a process that is completely subjective, which the valuation of stocks certainly is.

We certainly do not wish to penalize stocks with a better outlook by using a formula like price to current earnings which perceives them as less valuable than they are and also embellish the value of poorer performing stocks and companies, where the market sees less value but we somehow understand this as having greater value.

This huge mistake is important to understand first before we look at the merits of claims that price to current earnings ratios are back up where they were 20 years ago and then taking this as a sign of trouble. This is not only not something to worry about as it turns out, it actually measures the health of the outlook of stocks, where higher numbers mean better outlooks and lower ones mean worse outlooks.

Since it is the outlook that really drives stock prices and does so singularly, this is indeed something to pay attention to, but we need to fade the crowd here and take the opposite view, where a higher ratio is healthier and a lower one is representative of illness before we can seek health and avoid illness.

The right way to view this issue is to see it as recapturing the quality of health that was lost since the 2000 crash, and while it did take 20 long years, we’re finally getting there. This does not mean that there is a cap here in this area, unless you just want to imagine one, but while a good imagination can be helpful, if the truth gets shunned along the way, this practice is not a healthy one.

People think that present earnings cap future outlooks, and don’t even need to explain or justify this view for some reason, as it’s just accepted as fact by some people. They see stock prices rise, they see this as pricey, and pricey here essentially means perceived potential for growth. It’s not that there aren’t limits to this, but the limits are on how much this future growth in a stock’s price may be, and the present has absolutely nothing to do with this.

The crash of 2000 had nothing to do with earnings, past or present, and it wasn’t a matter of people thinking that earnings will skyrocket in the future proportionate to how much we bid up stocks back then, and then one day decided that they were wrong and the future potential was instead much bleaker and this caused a massive sell-off.

Earnings played absolutely no part in this crash, and there’s actually no reason to think that they even could. This crash was actually pretty unique since it wasn’t driven by crashing economic conditions such as the one in 2008 or the one that we saw in 2020. There was no recession involved here, and in the year that this happened, GDP growth was 4.1%, a number high enough that we have not seen one this big since.

Economic growth was strong enough that the Fed actually had to step in here and put a lid on it. As good as the economy was that year, we sure hit the wall with stock prices, and although price to earnings ratios were high prior to this collapse, we don’t want to commit the fallacy of reasoning that thinks that if something happens together with something else, there is a causal relationship between the two.

We need to revisit this era to look around and see what actually happened, besides the fact we blew up this balloon to epic proportions and then decided to burst it. It wasn’t outside forces that broke this bubble, not price to earnings ratios or anything else, we burst this one completely by ourselves without even any real negative influences to inspire us.

Bubbles are Created by Not Just Wind but How Hard the Wind Blows

We can think of potential stock bubbles as similar to the force of gravity, where it’s not the speed that matters, it is the acceleration. You can be travelling a million miles an hour or any speed as long as you don’t accelerate too much. The G forces of rapid acceleration can place us under intense physiological stress though and even see us pass out if we accelerate too fast, even though the speed this takes us too may be much lower.

While people pay so much attention to the bubble of 2000 bursting, they tend to focus very little how we blew it up before this happened. What gets missed is the uniqueness of this massive move and its role in causing the burst, which was caused by the historic level of price acceleration that led up to this, the thing that actually caused the burst.

It wasn’t just tech stocks that crashed during this time, as the stock market in general took a hit, although tech stocks were particularly hard hit. This was because we blew so much air into them so quickly that they had so much more to give.

It’s worth taking a look at how this played out in 1998-2000 to get a feel of the kind of air we’re taking about, far more than we ever see usually. We’ll start at the beginning of 2008, with the Nasdaq 100 at 956, and for comparison, the S&P 500 at 1227.

By March of 2000, a little over a year into things, the Nasdaq had risen to 4816 and the S&P 500 to 1527. That’s an annualized return of 20% for the S&P over a year and a quarter. Nothing remarkable at all here and 2019 was a better year for this index in fact.

The Nasdaq had an annualized return of 392% during this time, and that’s simply crazy. This degree of acceleration is extreme, technical analysis tells us that the steeper the mountain is on the way up, the steeper the mountain tends to be on the way down as well, and this one turned out to be Mount Everest.

By the time 2000 was over, 9 months after the summit was reached, things really slid downhill, and the Nasdaq 100 had dropped all the way to 2631. It’s worth noting that even a mountain this steep doesn’t just see people fall off of it to their death, and even though dropping 45% over 9 months is certainly a lot, it’s not that people didn’t have plenty of time to get out unless they were in a long coma and woke up from it much later in the fall than this.

It is also worth mentioning that if you just bought at the start of 1998 and did go into a coma and came out of it at the end of 2000, you’d still be up 175% in two years, not too shabby to say the least. There was even a lull in the action in the first few months of the move down, where the index dropped to 3138, back up to 3790, down again to 2897, back up to 4041, down to 3477, and then back up to 4147, all in just 4 months. This was a trader’s dream and a lot of money was made very quickly by those who play both sides of a move.

It wasn’t until September of 2002 that we reached the base of this mountain, right around where we started 1998 at, with the Nasdaq putting in a low of 830 and the S&P 500 dropping to 794, where the two were once again fairly close. That’s the last time they were close though as the Nasdaq has grown over 12 times in the 18 years since, with the S&P 500 only growing 3 times what it was back then.

1200% over 18 years does seem like a lot, and it is a lot to be sure, but that’s only an average of 67% per year, which is a much gradual acceleration than the massive 392% annualized return during the leadup to the crash. People just aren’t scared of falling off a mountain like they were then because this one is far less steep. Acceleration rates are what matter here, and there’s a good reason why, and it has to do with the reason why people sell, out of concern or fear.

Technical analysts would describe the phenomenon here as excessive profit taking, and while there were lots of that, people don’t take profits unless they are worried. When you have such a steep climb and you start to fall, that produces a lot of worry indeed, and people scramble to take their profits because they are afraid that they will disappear.

None of this had anything to do with earnings. If price to earnings was actually the issue, we would see some concern as things go from 20 to 25 to 30 on the way up, but no one cared. Once we begun the journey downward, even if 30 bothered them, this was not a case where reduced earnings did anything, and if it took 30 to panic people, once we got below that, everything should have been fine. It sure wasn’t and the Nasdaq ended up giving up 83% from top to bottom, and there’s only one thing that causes this, the effects of fear.

Fear is the only thing that causes crashes to happen, even ones much smaller than this. We sell off far more than the fundamentals would suggest, and that’s why stocks are such bargains when the panic ends. Price to earnings ratios go down, and we still sell as they continue to decline, like we just saw with the 2020 crash. This was no bubble though, and in fact if people were worried about stock prices and price to earnings ratios being too high, they had all the extra excuse they needed to break this bubble if there was one and especially not see the Nasdaq trading considerably higher than before the COVID panic hit, as we are left with both the pandemic concerns, the huge economic damage, and the big hit that earnings have taken.

We no longer blow up stock index balloons like we used to, and there’s no question that the enthusiasm got way out of hand in the late 1990’s. If we were back in 2000, we’d be telling you to run for your lives, or even better, short these indexes, just like we told you to this past February. We even jumped the gun a little by calling this crash a little too soon, out of an abundance of caution, although after a couple of days things did settle down. When the real bear showed up though, one day of its presence was enough for us to bail and flee to bonds.

It’s much easier to make these calls when you understand the most basic principle of stocks, that they do not move from earnings but from emotion, the emotions of happy excitement and especially by fear. We haven’t shown yet that we’re ready to freak out again right now, and we can be very confident about this given the recent chance, although who knows what the future brings.

This is why we need to pay attention to the things that matter, and what matters is the mood of the market. We don’t care if people like Ned Davis are afraid, as neither he or his confused understanding of stocks mean anything. We do care a great deal about when the mob starts to panic, and that’s what we all need to watch for. As mountain climbers, we need to keep our eye on the mountain and particularly watch our step when we see a lot of people falling.



Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.

Contact Robert:

Topics of interest: News & updates from the Federal Deposit Insurance Corporation, Retirement, Insurance, Mortgage & more.