Federal Reserve Chair Janet Yellen's statement about "stretched valuations" is getting some play this morning, but it should come as no surprise. She is right to raise the issue.
In a report provided to Congress in conjunction with her testimony, Yellen noted that "valuation measures for the overall market in early July were generally at levels not far above their historical averages," but then made this comment: "Nevertheless, valuation metrics in some sectors do appear substantially stretched-particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year."
What smaller firms in social media and biotechnology could she be talking about? Heck, that's not hard to figure out.
I wrote about this in my Trader Talk last week.
There are several obvious culprits.
Pandora (P) at $5.5 billion market cap, is trading at 156 times forward earnings.
Groupon (GRPN), at $4.4 billion market cap, is trading at 67 times forward earnings.
Zynga (ZNGA), at a $2.8 billion market cap, is trading at 150 times forward earnings.
In biotech, most trade at multiples well north of 20. Many make no money at all.
Among smaller firms, Cubist Pharmaceuticals (CBST), with a market cap of $5.1 billion, trades at 129 times forward earnings
Alkermes (ALKS), with a $6.9 billion market cap, is trading at 96 times forward earnings.
Akorn (AKRX), with a $3.6 billion market cap, is trading at 40 times forward earnings.
It is no surprise that a couple sectors have stretched valuations. They have stretched valuations because investors believe these groups will see explosive revenue and (eventually) earnings growth, if all the potential is realized.
Of course, that usually does not happen. There will be many failures.
And, often, investors will simply run out of patience, en masse, with an entire sector.
Which is exactly what happened with the dot.com bust in 2000.
It is in the nature of all momentum stocks to have stretched valuations. At some point, they come down to earth as they stop periods of explosive earnings growth.
That's exactly what happened with famous momentum names like Microsoft (MSFT), which was the Mother of All Momentum Stocks during its period of explosive earnings growth in the mid-1990s. MSFT went from $1.4 billion in net income in its fiscal year ending in June 1995 to $9.4 billion in the period ending in June 2000.
Of course, many other names in that period never had a chance to mature. They simply ran out of capital, many without making anymoney at all.