You may think that we are already in a Tech Bubble...and if you do then you are sorely mistaken. But we do have all the ingredients for a Tech Bubble. In this post we share our views on why and what to do.
What is a bubble?
Asset bubbles came into the mainstream vocabulary after the DotCom Bubble. The term "bubble" is used so often that it has ceased to have much meaning anymore. This is unfortunate because it obscures a true phenomenon that present huge opportunities and risks for investors.
Eugene Fama and Robert Shiller both won the 2013 Nobel Prize for their work on market efficiency ... despite the fact that Robert believes in bubbles while Eugene does not. Eugene is proponent of the efficient market hypothesis (EMH). When asked if he thought markets were efficient during the recent Financial Crisis, Fama said, “I think [markets] did quite well in this episode. Prices started to decline in advance of when people recognized that it was a recession and then continued to decline. There was nothing unusual about that. That was exactly what you would expect if markets were efficient.”
Robert Shiller predicted both the Dot-Com and Housing bubbles as documented by the publications “Irrational Exuberance“. The first edition, which featured the now famous Cyclically Adjusted Price to Earnings (CAPE) ratio, was released the same week the NASDAQ Composite began its 78% decline peak-to-trough. The second edition came out 14 months before the peak of the housing bubble and subsequent drop of 38%.
Cyclically Adjusted Price to Earnings (CAPE) Ratio
During the Dot Com Bubble the CAPE reached a high of 44 ... indicating that the price of stocks in the S&P 500 was 44 times the inflation adjusted earnings over the previous 10 years. That was far higher than any time in history including the peak before the Great Depression at a CAPE of 30. This was the main reason that Robert Shiller believed the stock market to be in a bubble. But there were other reasons.
Shiller essentially defines a bubble as irrationally exuberant buying of an asset until its prices can no longer be justified by fundamentals. So there are two parts we need to define...
Divergence from Fundamentals
Let's take a closer look at both in turn...
George Soros is another widely regarded expert in predicting asset bubbles including the 1992 Black Wednesday UK currency drop and 2008 Financial Crisis. His Reflexivity Theory provides a useful complement to Robert Shiller’s model as it focuses on the psychological aspects of bubbles.
Reflexivity Theory, when applied to financial markets, essentially states that financial asset prices diverge from fundamentals when driven by a self-reinforcing “narratives” which can propel investors to buy long after any rational justification can be found. The reason is that asset prices, unlike the weather or physical laws, are decided by market participants. If all market participants wake up tomorrow believing that the sky is green, they can look up into the sky and realize their mistake. However, if all market participants wake up tomorrow believing that interest rates will stay lower for longer, then all financial asset prices will rise and market participants will be emboldened with new confidence in their investing prowess, and double down.
Reflexivity Theory provides a necessary step in our formula for identifying asset bubbles. The self-reinforcing narrative is the cause of the bubble. It justifies an observation that prices have “diverged from fundamentals”. If we fail to identify this narrative in the media then we may be confusing a “divergence from fundamentals” with a “regime change”.
The psychology behind the “self-reinforcement” mechanism is what can overcome what are usually efficient markets. The specific heuristics involved are well known, but often ignored by traditional economists and other advocates of the efficient market hypothesis. Charlie Munger provided a near comprehensive list of these heuristics in his June 1995 speech, “The Psychology of Human Misjudgment“. Heuristics most relevant to the formation of asset bubbles include:
Self-confirmation bias ... the act of seeking out information that confirms our prior beliefs.
Pavlovian association ... the act of misconstruing past correlation as a reliable basis for decision-making.
Reciprocation tendency ... the act of doing more of something that has recently made you feel good (like making money on an investment).
Over-influence by social proof ... the act of placing too much weight on the conclusions of others, particularly under conditions of natural uncertainty and stress.
These heuristics compound on each other in the formation of a bubble.
The “narrative” starts gathering steam with a fast run-up in prices. This run-up gives early investors a heavy dose of self-confirmation bias. The good feeling of mark-to-market gains leads to a reciprocation tendency exhibited by buying into the trend. Others see the move and are compelled to join due to over-influence by social proof. After a while the act of buying into the trend takes on a Pavlovian like response where investors react to rising prices like dogs to the dinner bell.
Now let's look into the second part of a bubble ... divergence from fundamentals...
Divergence from Fundamentals
Many view a sharp run-up in price by excited investors as a "Bubble". But it's not a bubble...if the price can be justified by fundamentals. And therein lies the problem with Robert Shiller's definition of Bubble. Everyone has their own view on the "Fundamentals".
In our view...there is a better definition of Bubble...that proposed by Clifford Asness, a former Fama PhD student and hedge fund manager. He says that one of his “pet peeves” is that “an asset or a security is often declared to be in a bubble when it is more accurate to describe it as ‘expensive’ or possessing a ‘lower than normal expected return'…the term bubble should indicate a price that no reasonable future outcome can justify.”
Many viewed Tesla as being priced above "Fundamentals" but there were (and still are) scenarios that can justify the price. For example, if Tesla is the first to achieve autonomous driving and captures most of this multi-Trillion dollar market ... its current price of $600 Billion is easily justified.
Conclusion: We believe that a Bubble can be defined solely as a price that no reasonable future outcome can justify. However, it is useful to understand the irrational exuberance and narratives behind a bubble, because that provides an additional check on our thesis behind fundamentals. If we believe that there is no scenario in which a price can be justified...but we don't see evidence of irrational exuberance...then we may need to question our view on the fundamentals. We also want to see irrational exuberance supported by a strong reflexive narrative, because prices driven up by such a narrative tends to reverse quickly...providing a clearer investing opportunity.
Let's turn now to some recent bubbles and put this theory into practice.
Lessons from recent Bubbles
Let's take a look at the recent Dot Com, Housing, and Crypto Bubbles to see what signs we can point to as objective evidence of a "Bubble" defined as prices that no reasonable future outcome can justify.
Dot Com Bubble
In 2000, the “narrative” was that internet companies without a plan for turning a profit could continue to grow their share price. We see today that the promise of what the internet could bring was correct. That's part of what made the Dot Com so compelling. The Internet was real! The Dot Com period certainly did have a lot of irrational exuberance ... but not initially. It started with the Netscape IPO in 1995 which tripled in price in just a few short months.
Investors and entrepreneurs started jumping into the market. Skepticism gave way to excitement as the stock market rose and the psychological heuristics like confirmation bias took over. By 1998 many companies and investors hoping to ride the coattails of Netscape's success came to market. By 1999 a record 117 IPOs doubled the first day they entered the stock market. Many had no profits...some didn't even have revenue.
Robert Shiller pointed to the CAPE ratio as his reason for calling the Dot Com price levels unjustified by fundamentals...but there was an even better measure. The dividend yield on the S&P 500 fell to nearly 1% as a time when one could earn 6% on Treasury Bonds. Now that's a bubble.
Then the Dot Com stock market collapsed. No one is sure why, but we like a theory suggested by the Reformed Broker who suggests that perhaps the article by Barron's on March 20, 2000 helped turn the FOMO to Fear. Barron's featured a cover article titled "Burning Up; Warning: Internet companies are running out of cash—fast", which predicted the imminent bankruptcy of many Internet companies. This led many people to rethink their investments.
Eventually reality catches up to investors...but in a Bubble it's at a point where prices cannot be justified by any reasonable future outcome. There was widespread fraud, IPOs with no revenue worth hundreds of millions, and yields on stock indexes that were a fraction of less risky bonds against which they compete for investor attention.
The Dot Com Bubble was a classic bubble ... but so was the Housing and Crypto Bubbles which we discuss next.
Recognizing a run-up in prices is easy. The hard part is defining and measuring “fundamentals”. In 2000, stock prices were high relative to “fundamentals” which Shiller defined as the 10 year average of corporate earnings (i.e. cyclically adjusted price-to-earnings or CAPE). In 2006, home prices were high relative to “fundamentals” which Shiller defined as household income and rental rates. With the benefit of hindsight it is easy to see that these assets were overpriced.
One explanation is that it is notoriously difficult to time when a bubble will reverse. Alan Greenspan once said that, “The nature of a bubble as I would define it makes it impossible to determine when it will deflate.” However, at some point we have to accept that a bubble call is simply wrong or else the meaning of the word “bubble” losses significance.
A second explanation is that it is very difficult to distinguish between a “divergence from fundamentals” and a “regime change”. A divergence from fundamentals implies that the prices have moved away from their “intrinsic value” which is generally calculated using “fundamental” drivers or characteristics. A “regime change” refers to any change in the market that redefines what the fundamentals are and/or their relation to an asset’s “intrinsic value”.
In 2006, the “narrative” was that home prices could not fall. Like the Dot Com Bubble the narrative was self-reinforcing because the more people believed that somehow “This Time is Different", the more prices rose, confirming their belief in the narrative.
This narrative led investors to ignore the risks of lending to people that had poor credit. Subprime loans are the primary example. We call them subprime loans now...but before the Financial Crisis they were simply called mortgages, and everyone paid their mortgage, or so the story began.
One of our all-time favorite commercials features a character named Paul. "The uncertainly of getting a home loan made Paul ... irritable" (as he pops a child's balloon), but nothing can get Paul down after getting a loan from Washington Mutual (even his dentist drilling the wrong tooth). Perceptions of risk in mortgage lending were very low before the Financial Crisis.
Subprime lending exploded starting in 2004 to unprecedented levels. But it wasn't just that many borrowers had poor credit. Many borrowers got loans even though they didn't have jobs, or if they had jobs they could not afford the interest after adjustable rates jumped in 2006 and 2007.
What made the prices on mortgage bonds so high that no reasonable future outcome can justify is the fact that so many were guaranteed to end in default. That is why Michael Burry was so sure about betting against it that he put his entire portfolio in credit default swaps. He didn't get lucky. He looked at the mortgages backing the mortgage bonds...something no one else was doing...and saw that many were already going bust.
Rising interest rates likely helped contribute as well. As rates rose the affordability of mortgages fell making it harder for borrowers that could not pay their mortgage refinance. But the reality on the ground was one filled with fraud. Just like late into the Dot Com Bubble ... crooks come in and look for ways to take advantage of home buyers and investors willing to buy and invest at any price. The Housing Bubble was already baked into the market no matter the underlying interest rate.
A bubble cannot form without a self-reinforcing narrative. It’s this narrative that provides a potentially credible explanation for how a price could diverge from its intrinsic value. And the breaking of that narrative is what leads to the reversal in prices back to fundamentals. Even with zero interest rates and quantitative easing the Housing Bubble continue to deflate for four years as oversupply of homes...many made so fast they were already falling apart...faced a credit market that once again demanded income verification.
So that in a nutshell was the Housing Bubble. It took a decade from the time home prices started rising in 1997 to the Financial Crisis to play out. But some Bubbles are faster...
The Crypto market has actually gone through three Bubbles and crashes since the Bitcoin White Paper was first released by Satoshi Nakamoto on October 31, 2008. The paper is one of the greatest narratives to support an investment in history...and Bitcoin returns reflect this fact. Bitcoin has going from being worthless to more than ten times the value of an ounce of gold since its creation.
Crypto-assets like Bitcoin is the last asset class we will discuss, the total global value of which stood at a tiny $190 Billion...with a “B” at the end of 2019. Bitcoin is the best performing asset of the past decade...despite several bull and bear markets, some of which sent Bitcoin down to 10% of prior all time highs.
The most recent Bubble peaked in late 2017... but began at the end of the prior peak in mid-2013. Few even knew Bitcoin existed at the time, but by late 2016 the crypto market was started to get more national attention. By early 2017 there were about 500 total crypto currencies. But by the peak in late 2017 there were over 2,000. Where did they come from?
This was our first blog post on Twitter (below) back in March 5th, 2017. We later updated this research for an article we published on Seeking Alpha about why Crypto should be viewed as a new asset class. Our reasoning was sound...making 2017 one of the best investing years we have had. But what started as a sound investing decision quickly turned into irrational exuberance.
Our biggest holding was Ethereum...a smart contract platform that allows the development of contracts that execute without any need for a third party to enforce. That's the use case, and if that doesn't make sense to you then listen to our periscope on the subject.
One of the first use cases for the Ethereum smart-contract was the initial coin offering (ICO). In an ICO...the creators of a crypto-asset sell their new coins to buyers that wish to use the coin for a service. Augur became the first ICO in the fall of 2015. Buyers of the Augur coin can use it to participate in a decentralized prediction market. What makes it valuable is that prediction markets are illegal in some countries but because Augur runs on the decentralized ethereum blockchain you can participate anywhere and anonymously.
What started as a legitimate use case quickly attracted fraud and scammers. Just like the last two years of the Dot Com Bubble...investor demand at any price led new "companies" with nothing more than idea to raise millions. The fact that new ICOs were raising millions without much of a plan for building out their dreams was what made it a bubble.
It was relatively easy to copy the code to create a new coin on the Ethereum Blockchain, so valuations in the many millions for nothing more than an idea was clearly irrational exuberance. By December 2017 the pervasive fraud and valuations on new coins of no value in the many millions was clear evidence to us that the market was in a Bubble.
But like the Dot Com Bubble ... there was a powerful truth behind the Crypto run-up in 2017. Crypto prices fell 80% by the end of 2018. Speculators and gamblers exited the market. Some made money. Many lost money. But the army of nerds developing the value of the Crypto market remained. By May of 2019, volumes traded on crypto exchanges had already doubled compared to the peak of the 2017 Bubble. Today's those volumes are five times larger than the Bubble peak while prices on aggregate are still below 2017 peak levels.
Bitcoin just broke above $20,000 ... so now some are saying the Bubble is back. But interest in Crypto is only just starting to pick up again (below). It's not a bubble until we reach a price that no reasonable future outcome can justify. What would that be for Bitcoin?
Ark Invest has a price target on Bitcoin of $140,000 ... supported by some straight forward use cases that are practical today such as interest from investors in emerging markets that have little faith in the value of their home countries fiat money, adoption for international settlements, and taking market share from gold as a more useful store of value given its acceptance by hundreds of businesses and ease of use thanks to payment platforms like Square and Paypal. Would a $140,000 price tag on Bitcoin be expensive? Yes! Would it constitute a Bubble? No.
So what would constitute a Bubble price for Bitcoin? That's hard to say...but if Bitcoin Hoddlers start talking about the dollar going to zero and Bitcoin's market cap gets well above $3 Trillion then that would start to look like a Bubble. Bitcoin is not going to replace fiat money. But it is likely to grow in adoption for many use cases. Other tells for Bitcoin being in a bubble would be the Google Trends level of interest and the amount of new fraudulent cryptocurrencies coming on the market that double in price on day one.
The value of the Internet and a decentralized global currency are hard to overstate.
But we think that the coming Tech Bubble is going to be bigger.
More to come...