Are We in A Bubble?
Today some are comparing the rise in Technology stocks to a bubble. Are we in a bubble? In 2000, I was a business student at Clemson University. I recall sitting in a grocery store parking lot, listening to a business news report. This was before we had market news and the internet on our cell phones. I don’t recall the name of the company being discussed, but some of the numbers caught my attention. I quickly grabbed my financial calculator and found that the company’s stock price was more than 100 times its expected earnings for the next year (the historical average is about 16 or 17). The company had a web address but didn’t even have a building. We now refer to this period as the Dot Com Bubble.
What is a bubble?
A bubble is an increase in asset prices to levels that aren’t justified by conventional methods of valuation, followed by a rapid contraction. Economists have identified five stages of a bubble.
1. Displacement – This is a period where investors are initially attracted to a concept or the idea of something tied to an asset. We saw this during the Dot Com Bubble, where investors fell in love with any company with Dot Com in their name. Following the Dot Com Bubble, there was a sharp decline in mortgage rates that eventually led to the Housing Bubble.
2. Boom – Excitement gains momentum, and prices begin to rise. The Fear of Missing Out sets in, and more investors are attracted. Media attention fuels widespread interest as prices continue moving higher.
3. Euphoria – At this stage, investors’ enthusiasm for the investment theme reaches a fever pitch. There seems to be no price too high as described by the “greater fool” theory suggesting there will always be someone who will buy the asset at a yet higher price.
4. Profit Taking – There comes the point when some investors recognize the bubble, believe it’s about to pop, and are willing to sell. Trying to time this phase is a fool’s errand. As economist John Maynard Keynes said, “the markets can stay irrational longer than you can stay solvent.”
5. Panic – As the selling begins, prices start to fall, and investors all run for the same exit door at the same time. Panic selling exacerbates the price decline, and the bubble pops.
The first recorded economic bubble, known as “Tulip Mania,” occurred in the Netherlands between 1636-1637. During this period, the Dutch Republic was an economic and financial superpower. Tulips were considered a luxury and a sign of wealth. Owning Tulip bulbs became a status symbol, and the prices of various varieties began to rise. At the peak of frenzied buying, a single Tulip bulb could cost ten times an average worker’s annual salary or as much as a house. As quickly as it started, in February of 1637, Tulip prices plummeted, and fortunes were lost. Today we recognize that the prices paid for Tulips during the Tulip Mania were outrageous. At the time, many investors thought the prices were quite reasonable. Tulip Mania demonstrates how difficult it can be to recognize a bubble during a period of euphoria.
“History Doesn’t Repeat Itself, but It Often Rhymes” – Mark Twain.
I don’t think we’ll see a repeat of the Dot Com Bubble. Lightning rarely strikes twice in the same place. Today technology is an intricate part of our lives and the global economy. Unlike 2000 most of the companies in the technology sector are real businesses with real revenue and actual earnings. The issue is that much of recent market gains have been narrowly concentrated in just a handful of technology companies. It’s yet to be seen if earnings will rise to justify current valuations. At some point, fundamentals always matter. Having an investment strategy based on economic fundamentals and reasonable valuations will help an investor avoid being caught in a bubble when it pops.
A video companion can be found at https://youtu.be/IuhlRS9dVYw
