Is the Nasdaq Overpriced?

by: Eddy Elfenbein

Eddy Elfenbein submits: I often hear people say that the tech bubble never went away, it was simply displaced to the housing market. Please! The housing market is nowhere near as crazy as the tech bubble was. In fact, it’s almost hard to explain how unusual the Nasdaq was in the late-90’s.

Here’s a quick rule-of-thumb I use. Over the last 20 years, the level of the Nasdaq has usually been about one-fifth that of the Dow (in other words, five Dow points for each Nasdaq point). Sometimes it goes higher, sometimes lower, but it usually hasn't strayed far from that ratio.

To be more specific, the Nasdaq-to-Dow ratio has averaged 18.8% since 1986. The standard deviation has been 1.8%. For 82% of the time, the ratio has been bounded by 17% and 22%. Looking at the graph below, you can see that it’s been a fairly consistent relationship:

You may have noticed that something seems to be missing from the graph. No, your eyes aren’t playing tricks on you. I excluded a 27-month period from December 1998 through February 2001. OK, get ready for this. At the bottom of this post is what the full graph looks like.

Now do you how out-of-whack the Nasdaq got? It didn’t just get to the edge of the range. It demolished the range. The Naz peaked at 50.8% of the Dow. That's 18 freakin' standard deviations above the mean. That occurrence is so extreme, one has to ponder the cosmos to put it in any kind of context. We’re talking one over a number with 70 digits. That’s pretty damn small.

Many people think that the tech bubble happened throughout the 1990’s. Not really. The episode was very brief. What’s interesting about the chart above is that if you gaze at it for a bit and see the 27-month hole, your mind’s eye begins to bridge the gap. But of course, that wasn’t what happened. If you had taken a 27-month nap, you would have assumed not much happened.

So where does the Nasdaq stand now? A few days ago, the Nasdaq finally burst through 21% of the Dow, for the first time in five years. If I were a market-timer, this would lead me to think that the market is getting pricey. Since I’m not, it leads me to think that the Nasdaq is getting pricey.

In the larger view, the Nasdaq is high, but it's still well within the normal range.
