Why investors should be preparing for a Nasdaq 5000

This time it will be different—is that a good or bad thing?

The return of the Nasdaq Composite Index to 5,000—a level it has not seen since the dot-com bubble in March 2000—is coming sooner or later, but will it be significant?

There will be a debate between investors who say, "The last time we were here, the market was overvalued and so we are going straight down," and those who will argue, "This new record demonstrates how the tech sector has developed; valuations are not extravagant, and this will bring in a lot of new investors."

So which one is it? And what should investors do about it?

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There is no doubt that technology stocks have come a long way in the past 15 years, and this time, really, it will be different. For a number of reasons:

  1. All of the other major averages, at or near record highs, each contain a big slug of technology stocks.
  2. There are plenty of sector ETFs that track various technology indexes, giving investors less reason to get all geared up about the Nasdaq Comp's resurgence. Simply put, the index has a lot more competition these days—excellent competition—as a tech-sector barometer.
  3. The listing standards of the Nasdaq Stock Market are still such that it remains the place for lesser-proven companies to list, but since the Comp is a market capitalization–weighted index, the smaller companies are drowned out by a handful of giants: Apple, Microsoft, Intel, Cisco Systems, Google and Facebook, to name a few.
  4. And while it is still tech heavy for a large index, technology no longer dominates its components like it used to.

The first thing investors should do is take a look back at what went wrong in the original dot-com bubble. You can learn a lot that's still relevant to tech investing.

A stroll down memory (chip) lane

Lycos. Excite. Netscape. Global Crossing. And so many other names faded into oblivion. There were new phrases being uttered for the first time: digital subscriber loop (DSL), broadband, page views, Internet service provider and others. And, of course, the deals that seemed to validate the sky-high valuations.

  • AOL and Time Warner merged, but really, it was AOL that seemed to swallow Time Warner. Either way, an unmitigated disaster.
  • Qwest, a new fiber-optic communications company, bought a regional baby bell, U.S. West. The CEO of U.S. West was vocal in his angst about the deal. But no matter. The deal went through, the CEO of Qwest, Joe Nacchio, went to jail, and shareholders of U.S. West were badly burned.

Then there were the TV commercials—oh, the commercials! The ones I remember best (probably because I'm in the securities profession):

  • The "Does your husband have insurance?" … "Insurance? He's got money coming out of the wazoo!")
  • The one with the catchy tune, "My Discount Broker.com."
  • There was the one with the goofy kid advising his boss how to buy shares of K-Mart (which went bankrupt) online.
  • There was the one with the immigrants learning how to speak English, and they all stopped and rejoiced when someone uttered the words, "the stock market."
  • Even the behind-the-scenes tech companies were advertising. Sun Microsystems "put the dot in the dot com." And Lucent made "the things that make the Internet work." And these were considered among the highest-quality tech stocks! Lucent, one of the most widely held stocks in the history of the stock market, went from more than $100 per share down to $1.

The endangered-species list

The list of tech companies from back then that went extinct is too long to print. The Pets.com example is unleashed every so often as it is. More interesting, I think, are the many paths taken by—or fated to—the companies that still exist since the dark days of 2000.

AOL went from being the most valuable real estate on the Internet to an also-ran, and all these years later is now rumored as a potential partner for another fallen star of the original dot-com bubble: Yahoo.

Amazon was on the cover of Barron's back then, with the cover saying, "Amazon.Bom."

Apple was nearly nonexistent in the minds of the tech sector.

Microsoft was attacked left and right for being a monopoly. (Guess that's Google's job now.)

Dell was the manufacturer of choice for anyone buying a computer. Now it's back in the hands of its founder, Michael Dell, as a private-equity holding.

Cell phones were used for making phone calls. Period. Motorola's RAZR phone was a breakthrough just because it was so thin.

Google and Facebook didn't exist.

What makes a bubble a bubble

When the bubble burst, investors, of course, couldn't believe it—they wouldn't have bought into the tech bubble in droves if they did. Asset bubbles need constant validation, and nothing validates more than when everyone around you validates your own beliefs—other investors, professionals, commentators and analysts. As George Costanza said, "Just remember, it's not a lie if you believe it." That goes for the investing masses, too, who proceeded to make it even worse on themselves when they finally reacted.

First, investors sold out of the smaller, "speculative" Nasdaq stocks and parked in the "safer" names, the ones at the top of the Nasdaq 100, many of the heavyweights mentioned above, excluding Facebook and Google, of course. That helped to both mask the deterioration of the market and to drive the Nasdaq Comp to new highs into March 2000. But it turned out to be a false sense of security. Bad breadth is what it is called; not a perfect indicator, but worthwhile keeping an eye on it. The crushing went on until the Comp retreated by approximately 80 percent.

"There is no silver bullet P/E ratio, or any other metric, that definitively indicates an asset bubble or, for that matter, a reason to stay invested."

I don't know if the return of Nasdaq 5000 is a screaming bull signal or another canary in a coalmine, but here are a few additional takeaways to hopefully help you be better prepared to act after an extended runup in tech-sector valuations.

1. Obsolescence, competition and commoditization.
These are factors in any sector, but the damage done by them is especially acute in the technology arena. New products become useless very quickly, or eventually competitors come up with a new and improved mousetrap, or competitors compete on price with a similar or "good enough" product. All three of these happened in 2000. For all of history, there has never been a technology company that wasn't felled by one of these. Even mighty Apple almost disappeared twice.

2. The bears and the bulls will both get it wrong.
When the bears seem to warn too early and the bulls seem to change too late, how do you know who to listen to? We can all come up with our own "top 10" reasons to be bearish and bullish no matter what the market is doing. I say you listen to both, but be more concerned with being properly diversified and investing based on your own risk tolerance, time horizon, and goals. None of the talking heads will be there for you when the chips are down.

3. Don't abandon the sectors that aren't working.
In 2000 with technology, and to a large extent with financials in 2007, investors should have learned that they need to keep a lid on how big a portion of their portfolio becomes concentrated in too few sectors. Rebalancing isn't just for the flying Wallenda's!

4. Don't just know what you own—own what you know.
You've heard this countless times before, made popular by famed Fidelity Investments portoflio manager Peter Lynch. But seriously, when stocks are down, following this rule will help give you the confidence that you need to stick with your stocks when the inevitable correction hits us. You don't want to ask yourself "What the heck is this and why the heck did I buy it?" after it's down a lot.

Fifteen years is a long time, and the investing world has moved on from Nasdaq 5000. But let's not fool ourselves: The reality is that a whole new generation of investors will probably go down the same road again. So let's keep reminding each other of these lessons, and we'll create our own educational validation. Being better equipped to recognize the early signs of an asset bubble, or at least having the ability to question the conventional wisdom of the time, is a critically important exercise. Mathematics can help, but in the end it doesn't stop anyone. There is no silver bullet P/E ratio, or any other metric, that definitively indicates an asset bubble or, for that matter, a reason to stay invested.

By Mitch Goldberg, president of ClientFirst Strategy

Oh, what a difference 14 years makes

The current index has about half the components it did 14 years ago (4,715 in 1999 vs. 2,472 at the end of 2013).

Information technology has declined from 57 percent of the index to 38 percent (based on standard industry classifications, though by another classification system, known as GICS, information technology companies are still about half of the index).

The current components are on average about twice the size as they were in 1999—$1.2 billion on average vs. $2.5 billion market cap.

The top four companies of 1999—Microsoft, Qualcomm, Cisco and Intel—today have an aggregate market cap that is 44 percent of what it was in 1999.

At the end of 1999, Microsoft's P/E ratio was 73; today it is 18 percent.

Seventeen percent of companies no longer in the index were replaced due to regulatory noncompliance, such as bankruptcy, but 53 percent disappeared due to M&A.

The current index is still strongly oriented toward the information technology sector, as it always has been. Currently, 46 percent of the index by weight is classified as info tech; however, the extent of technology orientation appears to be receding.

In 1999 Yahoo, JDS Uniphase, Worldcom, Sun Microsystems and Dell were all among the top 10 Nasdaq Composite constituents. Today Apple, Google and Facebook have replaced these names. And outside of tech, Amazon (technically retail), Comcast and Gilead Sciences are also among the top 10.

Company valuations at the current index level are much more conservative than during the midst of the tech bubble of 1999/2000.

(Source: "The Nasdaq Composite Index, a 14-Year Retrospective," published by the Nasdaq in April 2014)