Investors and traders lost fortunes during this very difficult time.
Can anything be learned from this traumatic event? What lessons can we learn?
1. Valuation does matter.
During the Bubble which preceded the Great Bear Market, the valuations of large capitalization stocks especially tech stocks and tech stocks on the Nasdaq rose to unprecedented and astronomical levels.
Jeremy Siegel, in an article in the Wall Street Journal in March 2000 titled "Big-Cap Stocks are a Suckers Bet", says that of the 33 largest firms based on market capitalization (those with values greater than $85 billion), 18 of those were technology stocks, and their market weighted PE equaled 125.9. Mr. Siegel also notes that half of the large cap technology stocks had P/Es over 100.
Even if we look at the trailing PE of the more conservative of S&P 500 during the Bubble, we notice that the PE ratio went up to 35, when historical trailing PE is 14.1 and the trailing PE of the S&P 500 is 17.1 as of May 2007.
In addition, during this time, many people thought this was a different era, and that new methods were needed to justify the extreme valuations of tech stocks.
In 1999, Louis Corrigan writes about Michael Mauboussin in 1999, the head of value based research at C.S. First Boston. In this article, Louis Corrigan explains Mr. Mauboussin's position:
"We disagree with the consensus view that hype and hysteria drive the highflying valuations of Internet stocks," Mauboussin writes in the introduction. "Like all businesses, Internet companies are valued on their ability to generate cash."
"Mauboussin's work ultimately instructs investors to focus on FCF, to account for the whole cash economics picture."
- In Louis Corrigan's introduction to Mr. Mauboussin's work, Mr. Corrigan says:
"Traditional metrics like book value, the price-to-earnings (P/E) ratio, or even the price-to-sales (P/S) ratio are of limited use in valuing start-ups. They are particularly worthless in examining Internet start-ups."
Even Fed Chairman Alan Greenspan repeatedly warned people of "irrational exuberance".
With unsupportable valuations, it was only a matter of time before the market corrected itself to more reasonable levels. Valuations, apparently, does (eventually) matter.
2. Buy and Homework not Buy and Hold
People at the time, had often learned to "Buy and Hold" but people misunderstood this and applied this to Dot-Com stocks and high flying tech stocks.
Professor Jeremy Siegel, economist and author of "Stocks For the Long Run"(1st edition published 1994), proclaimed that over the long term, stocks have nearly always outperformed bonds and inflation. And that even if you bought some of the most expensive stocks at the worst possible time (such as the "Nifty Fifty" growth stocks of the 1970s), you could still make money as long as you just hung on.
Of course, people who followed this strategy without regard to price suffered during the Great Bubble and Bear Market.
In an interview with Money Magazine in 2004, Jeremy Siegel responds to a few questions regarding this:
Q. In the 1990s a lot of people used your finding that stocks nearly always make money in the long run to justify some pretty aggressive investing. Did you feel like Dr. Frankenstein -- you know, like, "I've created a monster"?
A. [Laughs.] Somewhat. I worried that people would interpret my message as "Just buy stocks without any attention to price."
Now I wish that in the second edition of "Stocks for the Long Run" I would have warned much more loudly -- but at that point it wasn't as out of hand as it got. And I was speaking out in 1999 and 2000 against what was going on with Internet and technology stocks.
Still, if you ride the bubble up and down, you do darn well indexing the stock market in the long run -- about 7 percent annualized, after inflation. I never told people that there wouldn't be a bubble or a bear market. I just said that indexing has done well over time.
Q. Would you modify the message now?
A. I now think that you could do better. After what I saw in 2000, I concluded that by applying some common sense and reducing your exposure to the hottest sectors and stocks, you could pick up about half a percentage point more return, on average, each year. If you just stay away from these manias, you've got an edge.
At the top of the bubble, I moved away from tech stocks. I repositioned my-self. I still held money in an S&P 500 index fund, so I didn't entirely sidestep it, but I moved a lot into value. And boy did that help me on the downside.
Then I said, if I did that and it helped so much, let me explore whether staying away from wildly priced growth stocks is something that works over much longer periods of time.
Q. You observed in "Stocks for the Long Run" that investors could make money even if they bought the high-flying stocks of the 1970s at their peak. Now you're saying that investors shouldn't buy expensive stocks. A contradiction?
A. I'll tell you why it's not contradictory. Among the fast-growing stocks dubbed the Nifty Fifty, those in the cheapest 25 did much better than the more expensive half. I mention that in the third edition of "Stocks for the Long Run."
When people are paying 100 times earnings for big companies, you better watch out.
But right now growth stocks look cheap to me. You shouldn't be afraid to pay for growth. The average P/E ratio of what I call the El Dorados -- the 20 top-performing companies since the inception of the S&P 500 -- was a few points above the market's average.
But none had a P/E over 27. [The S&P 500's average P/E today is 20.]
That links well with my findings on the Nifty Fifty. The most expensive ones -- the tech companies like Polaroid, Digital Equipment, Texas Instruments, IBM -- didn't do well at all.
Among the Nifty Fifty companies, only Johnson & Johnson, in retrospect, deserved a P/E over 50. The key, and it's a theme I talk about again and again, is not wildly overpaying. You almost never want to pay over 30 times earnings.
After this Bubble, I understand perfectly well why Jim Cramer preaches "Buy and Homework" and not "Buy and Hold." Valuation does matter and holding absurdly overvalued stocks is not a good idea over the long term.
While some stocks recovered from the bubble, others, like some of the dotcom companies, are no longer in business, or their stock prices are more than 99% from their all-time highs.
One exception to "Buy and Hold" would be if an investor used very broadbased indexed funds or ETFs instead of individual stocks. More on this in the Diversified section below.
3. Markets can remain irrational for periods of time
Valuations of many tech and large cap companies were very expensive, and for a time, they became even more expensive. Markets can remain irrational for periods of time. And during this time, the largest gains in these stocks were made.
This is a very difficult time for all. Do you invest in a massively overvalued stock that keeps on going up? Or do you invest in value stocks and smaller capitalization stocks that were underperforming the market? During this period, those who were nimble enough to trade momentum, and get out at the top were rewarded, but many who learned "buy and hold" and applied it to overvalued tech stocks were badly burned.
Then there are those who avoided the whole bubble completely (and many were criticized for underperforming the "market" during that time) and invested in value oriented stocks and small and mid capitalization stocks and were greatly rewarded. The period from 2000-2007 favored small and mid cap stocks and value stocks.
4. Diversification is very important.
People learned that diversification is very important. If someone had ridden the dot-com companies from Bubble to Bear market, that person would have lost most of the value in their portfolio. If a person had diversified into small cap, mid cap and value stocks during this time, they would have lost less money and during the recovery, these stocks outperformed the Nasdaq and the S&P 500.
From March 1, 2000 to July 30, 2007 (Adjusted for dividends):
- Nasdaq: -46% (4784.08 to 2583.28)
- S&P 500: +6.87% (1379.19 to 1473.91)
- S&P Midcap 400: +92.37% (468.71 to 866.31)
- S&P SmallCap 600: +96.67% (219.57 to 413.86)
If an investor had an indexed portfolio of ETFs representing the S&P 500, the Midcap 400 and the Smallcap 600 and invested near the Bear Market Peak on March 2000, and held to July 2007, that person would have had a decent return because of the large gains in the Midcap and Smallcap Indices.
5. Diversify from your own company stock
People also learned that they needed to diversify away from their own companies stock. People were very bullish on their own stock. But when the Great Bear Market showed itself, many of those people were laid off at the same time their company stock started plunging. This was a bad combination. People need to diversify away from their own company stock!
6. Many people survived the Great Bear Market of 2000-2002
While many people suffered and lost their jobs during this painful time, many people have recovered from such a brutal Bear market. We are still here and we are the survivors.
What's a correction after you've experienced a very deep and painful Bear Market?