Since it is requisite to add “and we know how that ended,” let’s look at how the dot-com bubble actually did end: The tech-laden Nasdaq Composite Index fell 78% while the broader S&P 500 index suffered a 49% fall. Despite the market carnage, the economic spillover was modest, with a modest eight-month recession from March to November 2001.
The key difference between then and now is valuations. At that time, some of the hottest tech companies had little revenue and no earnings. At the peak, the S&P 500 had a forward price-to-earnings ratio of 31; Nasdaq was closer to 70. The difference is that tech dominates today because it is so wildly profitable.
Tech stocks would indeed suffer during a recession, but there's not really much to suggest that valuations are spiraling out of control. In other words, it's hard to see how a tech bust itself will be the source of the next recession.
Federal Reserve: The unemployment rate is 3.5%, the lowest in more than 50 years. Companies eventually will find that they have trouble hiring workers and turn to pay increases to either lure people away from competitors or entice marginally attached workers back into the labor force. It is not hard to guess how that progresses. As salaries rise, so too does consumer spending. The increased demand for services and durable goods leads to an increase in prices. The inflationistas, despite being wildly wrong for the past three decades or so, begin once again to sound alarms.
The Fed raises rates, calling it an insurance policy against higher prices. It has no effect, so it raises rates again with the same results. Finally, 18 months and 150 basis points later, the impact on credit availability and cost is noticeable. This cuts into earnings, leading to layoffs and reduced business investment, which already is in the doldrums. The economy suffers a modest contraction.
Back in the fourth quarter of 2018, recession anxiety after the Fed raised rates seven times in 2017 and 2018 sent stocks into a free fall. There was also concern about rising trade tensions between the U.S. and China, increasing market volatility and a host of other issues. Although the yield curve didn't invert at the time, there was plenty of chin striking by experts confidently predicting recession, which as we now know has yet to materialize. Of course, it might have helped that the Fed switched from raising rates to cutting them in 2019, lowering them three times.
Investing into the teeth of those last recession fears, however, turned out to be great timing: If you bought at the low-point of the market slump in December 2018, you were rewarded with a 31% return during the next four quarters.
One of these days, the U.S. will have a recession. Let's hope you have your investment playbook ready—and the courage to use it to your advantage—when the next economic downturn comes along.
This column was provided by Bloomberg News.