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Is the Bubble Back in Stocks.......We Sure Hope So !

November 15, 2004

 

A quick glance at the P/E ratios of some of the most widely held stocks of today has several investors wondering whether the Internet bubble of 1998-2000 is back. Consider Google, which has shot up over $100 since its initial public offering to post a whopping Price to Earnings ratio of over 443. In comparison, General Electric's P/E ratio is a mere 23. The market is pricing in growth for Google 20 times that of GE......

And its not just Google, E-Bay is trading at 104 times earnings, Yahoo at 99.50, and Taser Intl at 100. If P/E ratios aren't your thing, consider the Dow Jones Transportation Average and Russell 200 index both hit all time highs last week. That's right - all time highs! If you're like me, your mutual fund statement sure isn't at all time highs.

So is the Bubble back? Maybe, but it sure feels different this time. The Nasdaq remains over 3000 points below the march 2000 high, or as system traders say - in a 68% drawdown. That's not bad when you consider it has risen over 700 points off the 2002 low, where it posted a max DD of 83.4%. (75% on a month end basis)

With the market making new highs and new lemmings rushing in to buy stocks as if 2000, 2001, and 2002 never happened, we have some advice: Get OUT while you can. Think about how you felt at the lows in 2002, about how worried you were about getting out at the lows, and try a Mark Cuban for a change - Get out at the highs!

But, you say, my stock broker tells me this time is different, that the market is really rolling now and its time to get back in the game. Well, the market may be rolling, but what about the risk. Does your stock broker even know how to measure the risks involved?

If you have ever transferred money from a stock account to a futures account, I am fairly certain you've been told one of the following:

• Be careful! You could lose everything.
• Do you know that Futures are one of the riskiest investments in the world.
• You're much better off sticking with a diversified stock portfolio.

Don't blame your stock broker for his lack of knowledge. He has been conditioned to think that way. The investing world remains heavily biased towards the stock market, and the Merrill Lynch's & Charles Schwab's of the world teach their brokers one thing: Stocks.. After all, it is simply un-American to not invest in our country's best companies - no mater how much fraud, losses, and bankruptcies they have.

In fact, the regulators spend countless hours and dollars trying to dissuade you from investing in futures. As you will see often in any materials from Attain Capital, regulations require the constant disclaimer of risk. (You will find a lengthy one at the bottom of this newsletter) Where are the disclaimers for stocks? Are stocks not risky?

Have you ever been told what the possible risk of your stock purchase was? Were you shown detailed statistics of that stock's max drawdown and its risk reward ratios? The odds are you have not. Why? because your stock broker either doesn't know what these are, or doesn't want to tell you how risky your stock purchase is.

90% of stock market analysis is based on the flimsy premise that the risk of an investment is equal to the volatility of that investment's returns. Your above average stock broker may be able to tell you about the risks of a stock purchase by calculating that stock's volatility through the standard deviation of returns. But this will not tell you anything about the worst case scenario, however. For that, investors must look at drawdown.

Drawdown, and more specifically the Max % Drawdown, represents an investor's maximum percentage loss during that investment. It is defined as the percent retracement from an equity peak to an equity valley. For example, a decline in an account's value from $100,000 to $70,000 would represent a 30% Max DD.

Some examples:

Buy 100 sh. CSCO @ $30 in 1999: Account Value = $3,000

CSCO hits 82 per share in 2000: Account Value = $8,200 

CSCO hits $8 per share in 2001: Account Value = $800 

CSCO currently at $13.50 per share: Account Value = $1,350

Drawdown = Account Low[$800] - Account High[$8,200] = (-$7,400)

Max DD % = Drawdown[(-$7,400)] / Account High[$8,200] = 90.24%

The Drawdown represents the return of an investor who got in at the absolute high, and got out at the absolute low. While many may scoff and say that would never happen, the trillions of dollars lost in the stock market in the last bubble tell a different story. Is it not wise to prepare for that worst case scenario. You simply can't know what the future brings, thus can't determine whether you are entering an investment at its peak or not. As for exiting the investment at it valley, that is a common practice brought about by many investors simultaneously coming to the conclusion that they've had enough .

The chart below shows some basic statistics for the major stock market averages, including Max Percentage Drawdown (Max DD), Sharpe Ratio, and Average Annual Rate of Return as compared with the same statistics of some popular trading systems. As you will see, the stock market averages are downright scary, with the average Max DD of a stock investment an alarming -48%. Simply put, the average stock investor has experienced a loss of close to 1/2 of her account. Compare that drawdown with the Max DD of the top trading systems, which is just under -30%.

By our math, the stock market may be the single worst place to achieve risk adjusted returns, with its high drawdown numbers and low average annual returns. Stocks offer a very high risk for very marginal returns. The below table compares the stock indices with two of Attain's recommended CTA programs as well. You can see that the CTA programs offer risk adjusted returns nearly double that of the stock market. Past performance is no guarantee of future results, but these numbers show you could have made twice the money for the same amount of risk by investing in one of these CTA programs versus a stock investment represented by the listed indexes.

It is really an unfair comparison, however, as we are pitting professional money managers obsessed with eliminating risk against an index of stocks which is susceptible to the whims of emotional investors. Our cross section of trading systems show much more attractive returns per unit of risk also. It is interesting to note the trading systems show higher drawdowns than the CTAs for the most part, but also higher returns. That is a reflection of diversification and active money management on the part of the CTAs, who put avoiding drawdowns ahead of generating oversized returns. .

So is the Bubble back? There are of course arguments both ways. But consider the following from a recent article in the magazine Business 2.0 penned by none other than the former king of Internet stocks, Henry Blodget:

"During the past century, according to data compiled by Irrational Exuberance author and Yale professor Robert Shiller, the S&P 500 traded at an average price/earnings multiple of about 16. At the last four major peaks (1901,1929,1966,and 1999), the P/E approached 25 or more, with an all time high of 44 in late '99....the S&P's current P/E is above 25 - higher than the 1966 peak.

So assuming that earnings grow at a typical rate of 6% per year during the next decade, the P/E must expand considerably for the S&P to post 10% annual returns. If earnings grow at that rate over the next decade and the P/E stays put, stocks should return about 8 percent annually, including dividends - less than we're accustomed to but solid enough. However, if the P/E follows its more likely course - regressing to its long-term mean- stocks will return only about 3% percent. And if earnings struggle-say, 4 percent growth-and the P/E drops below 10 (as it has in all previous major troughs), we will lose at least 3% a year."*

So are we approaching another bubble? Your guess is as good as mine, or Henry Blodget's above, but as a trading system investor, I sure hope so. The volatility and big moves to the downside another burst bubble would bring, could be a very attractive environment to many trading systems and CTAs given their need for volatile markets and low correlation with the stock market. One need only look to the last bubble, where the CSFB/Tremont managed Futures Index averaged a gain of over 8% per year as the S&P 500 lost an average of over 14% per year.

If you are hell bent on buying stocks at these historically expensive levels, challenge your stock broker! Call him tomorrow and ask for a report on the possible drawdown of your top 5 holdings. I guarantee you will get an answer somewhere between "What is a drawdown?" and "We don't have those kind of statistics..... have you seen what Google's been doing "

- Jeff Malec

*Reference: Blodget, Henry (2004). The Case for Slow and Steady, Business 2.0, November 2004, pg 134