The history of the stock market is filled with bubbles that inflate and burst. In a free-market economy, this phenomenon is fairly common. Most recently, the U.S. housing bubble of the early 2000’s wreaked havoc on the economy when it started to burst around eight years ago. In hindsight, these bubbles often seem so obvious that it is mind-boggling that nobody seems to notice them forming in real time. Of course, the handful of people that do see the bubble forming can make some major money when it bursts. Today I’d like to take a look at three large-cap stocks that might currently be experiencing bubbles in share price: Amazon.com, Inc. (NASDAQ: AMZN), Adobe Systems, Inc. (NASDAQ: ADBE), and Netflix, Inc. (NASDAQ: NFLX).

Exceptional Circumstances

Long before the housing bubble, way back in the prior millennium, enthusiasm for the monetary potential of the internet laid the groundwork for the dot-com bubble. One key element to most bubbles is the belief in the exceptionalism of the circumstances. In the late 1990’s, investors believed the internet would become such a cash cow that they flocked into any stock with a “dot-com” attached to its name. At the time, investors completely disregarded traditional stock valuation metrics such as price-to-earnings ratio (P/E). The belief was that the connectivity and access to information that the internet would provide was going to lead to an era of economic opportunity that the world had never seen before.

It’s hard to argue that the internet hasn’t provided unprecedented financial opportunity. However, the prominent belief at the time seemed to be, “It doesn’t matter how expensive stocks are because the internet is the exception to the lessons that history has taught us about stock valuation.” This belief in exceptionalism is always a dangerous belief to hold.

The Ghosts of Bubbles Past

In March of 2000, Jeremy Siegel wrote an article for the Wall Street Journal entitled “Big-Cap Tech Stocks Are a Sucker Bet.” In the article, Siegel challenged the belief that internet stocks were the exception to the rules of the market by noting that, “many of today’s investors are unfazed by history — and by the failure of any large-cap stock ever to justify, by its subsequent record, a P/E ratio anywhere near 100.”

Siegel focused on companies with extremely high P/E ratios at the time, such as Nortel Networks (1999 P/E of 105.6), Cisco (1999 P/E of 148.4), and Yahoo! (1999 P/E of 119.0). We can take this time  to have a brief moment of silence for Nortel, whose stock on the Toronto exchange tanked from C$124 to C$0.47 when the dot-com bubble burst. Nortel stock was eventually delisted from both the TSX and the NYSE, and the company filed for bankruptcy in 2009. Cisco and Yahoo! survived the burst of the bubble, but the stocks each took major hits. In January 2000, Yahoo! shares reached $118.75, but subsequently plunged 93% to $8.11 by September 2001. In March 2000, Cisco briefly became the world’s largest company by reaching a market cap of $555.4 billion.

By 2001, Cisco’s market cap was only $151 billion. Now, nearly 14 years later, Cisco’s market cap is $124.6 billion.

This time it’s different… right?

Shareholders of Netflix, Adobe, and/or Amazon, are probably well aware of the multiples at which these stocks currently trade. They have been holding their noses and swallowing them like cough syrup for quite a while. But for the shareholders that have completely had their heads buried in the sand, the current P/Es of these three companies are currently comfortably above Siegel’s threshold of 100.

Defenders of these companies argue that the companies’ high projected earnings growth rates justify these otherwise ridiculous P/E ratios. There’s no arguing that these three companies are rapidly growing, but so was Cisco in 2000. One of Siegel’s main points in his article was that, once a company reaches large-cap size, it becomes increasingly difficult to grow at such a high rate. However, assuming the companies actually grow their earnings at their current projected 5-year growth rates (according to finviz.com), the chart below includes the projected P/E ratio for these three companies five years from now.

Those projected P/E ratios are still extremely high. But here’s the kicker: the projected P/E ratios assume a 0% change in share price over the next five years. Siegel made similar projections for the companies mentioned in his article and assumed investors were expecting a 15% annual return from these types of high-growth stocks. Assuming a 15% annual increase in share price produces the following projected P/E ratios:

Assuming shareholders will make a 15% annual return over the next five years produces some pretty ugly projected P/E ratios.

Time to panic?

Just because a stock is trading at a high P/E ratio doesn’t necessarily mean that a crash is imminent. For example, Netflix’s P/E ratio has been over 100 since late 2012, and the share price has done nothing but rise since that time. And I’m not suggesting that Netflix, Amazon, and Adobe are terrible companies, no more than Cisco and Yahoo! were terrible companies back in 2000. But if you are a shareholder of these three companies or any other large-cap stock with a P/E over 100, you need to ask yourself these two questions: Is the astronomical growth rate needed to justify the current share price reasonable? Is my company truly the exception to Jeremy Siegel’s observation that no large-cap companies have ever justified this high of a multiple?

Want to learn more about how I analyze stocks? Or maybe you just want to be able to look sophisticated in front of your coworkers when they ask you what you are reading on your Kindle, and you’d prefer to tell them “Oh, I’m just reading a book about stock market analysis,” rather than the usual “Oh, I’m just looking at pics of my ex-girlfriend on Facebook.” For these reasons and more, check out my book, Beating Wall Street with Common Sense. I don’t have a degree in finance; I have a degree in neuroscience. You don’t have to predict what stocks will do if you can predict what traders will do and be one step ahead of them. I made a 400% return in the stock market over five years using only basic principles of psychology and common sense. Beating Wall Street with Common Sense is now available on Amazon, and tradingcommonsense.com is always available on your local internet!