0:11

Hi there, in this third video we're going to talk about another bubble,

Â which was due to excessive valuation.

Â And that's the so-called dotcom bubble, also known as the TMT bubble,

Â TMT standing for technology, media, and telecom.

Â So as a first chart, which I'm going to show you,

Â this one, there's going to be a quiz for you.

Â And you see that this quiz is going to be similar to the ones you had to do for

Â the 1987 crash.

Â Basically I would like you to find out by how much the equity

Â market is overvalued relative to the bond market using the Fed model.

Â So looking at this first chart, you see it here,

Â the evolution of the equity market between 1997 and 1999.

Â 1:09

That's the green line for equities and the same for the bond markets.

Â And well we know by now that it's not enough to just compare where

Â the equity market is relative to the bond market and say there's so

Â much overvaluation in this instance just comparing the two price indices, 81%.

Â You need to compare two valuation yardsticks.

Â And we know from the Fed models that these valuation yardsticks is

Â the earnings yield for the equity market and the bond yield for the bond market.

Â So question to you, quiz to you, if we look at this chart now and

Â we see that the bond yields is at 6.7%,

Â and the earnings yield is at 4.2%.

Â Using this 4.2% now, what would be,

Â what should be the P1,

Â the equilibrium price of the stock market such that

Â the earnings yield goes from 4.2 to 6.7?

Â Okay, so here's the solution to the quiz.

Â We start from the earnings yield at 4.2.

Â And we want to find out which P will give an earnings yield of 6.7.

Â So we rewrite the equation here,

Â 4.2 times P0 divided by P1 is 6.7, and we find P1.

Â And we find that P0 relative to P1 is that 6.7 divided by 4.2,

Â so today's stock market price is 59% above

Â what it should be according to the Fed model.

Â So there's an overvaluation of where the stock market should be

Â using this model of close to 60%, which is huge.

Â And did you remember when we discussed the biases which may occur

Â when we want to buy a security and

Â we have difficulties in selling that security when it's making losses?

Â And we used the example of Nokia.

Â Here we'll show you here the same chart, and indeed it was a bubble.

Â And we identified this bubble by some kind of similar yardsticks.

Â Here it's not the earnings yield, but it's the inverse of that earnings yield.

Â It's the PE ratio.

Â And we use the PE ratio of Nokia, of the telecom sector, and possibly of the whole

Â market to find out whether there's an excessive valuation on the equity market.

Â 3:56

Indeed, with what happened in 2000, the market peaked,

Â the NASDAQ index was at more than 5,000, and it crashed.

Â And here we see that peak-to-trough the equity market tumbled by 46%.

Â This is a very painful bear market.

Â It lasts us two years.

Â And I remember I was working in a bank at that time, in an asset management company.

Â And every day you walk in and you see the market goes slightly up, and then down,

Â and then down again the next day, and then down again the next day, little by little.

Â And you see all these fund managers walking in their office and

Â being really grim and really sad.

Â And what happens in the market, basically,

Â impacts your personal life and makes it very difficult to stay motivated.

Â So here you see the two examples.

Â 1987 crash, boom, you get a sharp drop in the equity market.

Â And then it stabilizes and resumes pretty swiftly.

Â Here we get a painful bear market because it lasts two years.

Â It's more abrupt, the fall is more than 1987.

Â But what is more important, it lasts much longer.

Â So it impacts people behavior and happiness [LAUGH]

Â to a much larger extent than the 1987 crash.

Â 5:28

Okay, so the Fed model is a useful tool to assess whether equities are over or

Â undervalued vis-a-vis bonds, but the model also has its limitations.

Â And they are listed here.

Â Basically, the model is a simplification of

Â the real world on 3 grounds, I would say.

Â The first one is it assumes when we talk about earnings yield, it assumes

Â that basically looking at the earnings of a company, this is what you would gain.

Â So this assumption implicit there is that a company generates earnings,

Â and they give all these earnings to their shareholders.

Â So we basically here assuming that the dividend payout or

Â ratio is 100%, so that's assumption number one.

Â 6:23

Further, it assumes, and more importantly,

Â that there's no risk premium for holding risky assets.

Â Basically you say you hold equities or you hold bonds, and

Â basically you're comparing one against the other.

Â But normally you should be rewarded with a risk premium for

Â holding equities vis-a-vis bonds, and

Â here the Fed model does not make this assumption.

Â It further assumes, the Fed model, that basically we're comparing

Â the earnings yield, and this is defined in real terms.

Â It's E divided by P, and we are comparing that to a nominal measure of income,

Â the stream of income for the bond market which is its yield, so the bond yield.

Â So here we have a discrepancy.

Â On one hand we are saying the stream of income for the equity market

Â is in real terms and for the bond market, it's in nominal terms.

Â So it's a discrepancy here.

Â So now we know that equities can be overvalued vis-a-vis bonds.

Â So i.e., you can have a bubble.

Â But identifying a bubble does not tell you when it's going to burst.

Â And indeed, I remember early in 1999, I used the Fed model.

Â I was a Chief Investment Officer in a bank here in Geneva, and I used that model.

Â And I waved the red flag and say, equities are too expensive vis-a-vis bonds.

Â But the problem is if you go underweight equities versus bonds when you identify

Â the valuation excess, you may miss the last leg of the rally in equities.

Â And that's where you make a lot of money.

Â So the key question is, how do you invest your money in an overvalued market?

Â And the best way forward for

Â me when you are investing in overvalued market is to stay

Â invested just to capture this last leg of the rally,

Â which typically occurs at the end of an overvalued market.

Â But you buy some downside protections.

Â And you stay invested, but you have some downside protections against a fall,

Â which you don't know when it's going to happen.

Â Okay, in conclusion of these three videos, we saw that bubbles may occur.

Â And they are basically a speculative mania, which drives the price of an asset,

Â typically equities, the risky asset, above, but

Â it can also be bonds actually, above its fundamental value.

Â 9:16

Bubbles are hard to identify.

Â Indeed, when we talked about central banks,

Â this is the main argument that they use to say bubbles are hard to identify.

Â Alan Greenspan, as we mentioned,

Â used to say that we know that there's a bubble when it bursts.

Â So that is an explanation for why they refrain to act preemptively.

Â Although I think it would be a good idea, because we know

Â that central banks are much more effective in preventing

Â the formation of a bubble than in dealing with it once it's burst.

Â The Fed Model is something which you can use to identify possibly overvaluation

Â of a risky asset versus the non-risky asset, ie, equities versus bonds.

Â [MUSIC]

Â