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Paradigm lost

The Nasdaq composite index today represents the best and worst of US

capitalism and finance.

A list of its components demonstrates the enormous entrepreneurial drive

found in the US version of capitalism. But although some exposure to the

dynamic parts of the world&#39s leading economy is desirable, UK IFAs should

be wary.

A study of the Nasdaq index&#39s valuations highlights the reckless

abandonment of rational judgement and the willingness to borrow excessively

despite the risks.

Borrowing is best understood by examining margin debt – the debt that

people carry for making equity purchases. In February, margin debt climbed

by 8.9 per cent to $265bn following a 6.5 per cent rise in January.

Margin debt now accounts for 1.5 per cent of total market capitalisation –

the highest level ever. Margin debt also stands at 14 per cent of total

consumer credit, double its 50-year average, and represents 4 per cent of

personal disposable income.

About $530bn in stocks may now be on margin. As margin has grown, so has

the Nasdaq.

Studying the Nasdaq&#39s level is best done by reflecting on the past. The

growth in the Nasdaq index over time has far exceeded the growth in the

Nasdaq&#39s earnings.

As a result, the price/earnings multiple has moved up dramatically. Some

15 per cent of US companies now have a p/e that is negative, which is above

100. After trading between 20 and 40 for most of the 1980s and 1990s, the

Nasdaq composite p/e now stands at a massive 245.

These valuation levels are typically justified by explaining that we live

in “a new paradigm”. This is described as an economy which shows good

economic growth, low inflation and good corporate profit growth.

Many investors believe that if you are experiencing good economic and

corporate profit growth with low inflation, the multiple you pay for

earnings should be higher than normal. The question is, how much higher and

at what point do prices reflect high growth?

When I recently questioned a European retail analyst as to why he was

recommending a European stock which he believed would grow its revenues

from £15m today to £50m in three years but had a current market

capitalisation of £8bn, the response was that: “Times have changed.”

Times certainly have changed. However, although history does not repeat

itself, it does often rhyme.

Today&#39s valuations and economic conditions have the rhythm of the late

1980s in Japan. The table above shows how similar Japan&#39s situation in the

late 1980s was to the US status today.

Prices in Japan eventually became too high despite the “economic miracle”.

The year 1989 was the top of the stockmarket and the beginning of wealth

destruction and economic stagnation for the country as stock and land

prices began their long decline. This destruction continues today.

Although technology and communication stocks have soared, stripping out

the returns from technology from the S&P 500 illustrates how difficult it

has been to make a profit in non-technology stocks for the last 18 months.

In some cases, the declines in non-technology stocks are significant. This

is providing opportunities which IFAs need to examine for patient long-term


The tables below indicates how far down in price many stocks have fallen

and how cheap they are on the basis of p/e and yield. In effect, it

illustrates the bear market behind the bubble.

If the level of speculation in the stockmarkets and the valuation of the

indices bother you as advisers, take a look at mutual funds, which will

come into their own if speculation ceases to run wild.


Nikkei peaked on December 29, 198l Market cap/GDP = 155 per cent l

Interest rates rose by 175 basis points from

May 1989 to December 1989

Mieno appointed head of Bank of Japan on December 17, 1989

GDP growth = 4 per cent

GDP growth in five years up to 1989 = 3.8 per cent l Inflation = 2.6 per

cent l Overvalued currency

Biggest equity market in the world

Dow Jones to peak in 2000?

Market cap/GDP = 200 per cent

Interest rates rising

Alan Greenspan reappointed chairman of the Federal Reserve in 2000

GDP growth = 4 per cent

GDP growth in five years up to 199 = 3 per cent

Inflation = 2.5 per cent

Overvalued currency

Biggest equity market in the world


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