Is it a bubble now? Now? Now?

Dotcom

This time 25 years ago the world’s investors were beginning to wake from a speculative dream. The ‘dot-com bubble’ inflated into the end of the last millennium, with four corporate ‘horsemen’ – Dell, Intel, Microsoft and Cisco – at the centre of a gathering market frenzy. The mass-less possibilities of the internet briefly loosened the gravitational pull of corporate fundamentals on share prices. At the time of writing there are understandable concerns that history is repeating itself. So far, there seems significantly more substantial support from rising earnings this time around. However, as with the dot com bubble, investors should stay humble in assessing the potential of a new batch of technologies in real time.

Some history

In spite of the relative proximity of two of the more famous bubbles seen over the last 350 years, investors should be reassured by the fact that they are relatively rare phenomena. Using data from a range of countries going as far back as credibility allows, gives us over 100 years of equity market performance data to analyse. Yale Professor of Finance, William Goetzmann’s analysis of this impressive dataset finds that the probability of a severe market decline increases marginally if that market has more than doubled over the previous year. However, based on the same dataset, the chances of the market doubling from that point is still twice as likely as halving in value over the same time frame. In simple terms, a large price increase in markets is twice as likely to be followed by another year of high returns compared to a severe market decline.

As this suggests, it is notoriously difficult to separate the bubbles from the justifiable booms – at least without the benefit of hindsight. Generally, bubbles occur when investors push the price of the asset in question beyond what is revealed ex post to be their fundamental values. However, what can at the time appear exuberant to the hard-nosed investor, more often than not turns out to be changing reality - a step-change in technology or innovation.

Some things to keep an eye out for

Bubbles are frequently taught as examples of human fallibility - greed, gullibility and mass delusion - the madness of crowds. But how can you reliably measure madness? Is there a hard line, perhaps described by valuations, that tells sane from crazy? Its possibly more helpful for investors to think about whether or not two main conditions are satisfied. The first is a future you can almost touch, distinct from abstract optimism - a continent connected by rail, homes lit by electricity, commerce rewired by the internet. There is a feeling of inevitability. The second part makes this inevitable future cheap to own today - easy credit, leverage, instalment terms, securitisation, holding company pyramids - these are just some of the examples of this in the past. Across the various manias, the sales pitch is mostly about buying the future early. What translates these sales pitches into a mania is the credit environment – the ability to turn conviction into position size.

When it comes to the pop, you see how in a leveraged system, ‘belief’ has become the most important collateral. When prices ultimately fall, collateral (both tangible and intangible) then shrinks, credit tightens and the doom loop reinforces itself.

Bubbles have a role to play

Carlotta Perez, a British Columbian academic, observed that almost every major technological breakthrough required an asset bubble to progress. The point here is that rising capital markets acted as a giant (and necessary) magnet attracting finance and talent. These extra resources help solve the various problems and bottlenecks posed by the new technology. Perez’ techno economic paradigm is in tune with Suleman Mustafa (and other modern technologists) who emphasise the importance of superclusters of innovation. When these emerge, each new wave begins to buttress other innovations (like the impact of steam, electricity or combustion engines). The resulting diffusion of the new technology results in sharp drops in marginal costs, which further drive wider take up in the economy. Of course, this is a messy and disruptive process (as the last couple of decades pay ready testament to). However, once a breakthrough has occurred, there is virtually no way of stopping waves of products and innovation that ultimately always lead to comprehensive rewiring of most aspects of life, for good or for ill.

So far, the information revolution has not supercharged productivity to the degree seen in previous paradigms, (although more recent US data are starting to look more encouraging). However, many see the pattern of the last 25 years as entirely in keeping with past revolutions. Initially productivity falls as neither societies nor businesses understand how best to use the new technology, while many innovations ‘kill’ other parts of the economy. This process, including the bottoming out, can take a while. In the intervening period, technological breakthroughs aggravate inequalities, causing flare ups in polarisation and geopolitical tensions. There is more here for future articles of course!

Some risks to keep an eye on

The AI infrastructure buildout is obviously front and centre in the risks column. This is flipping some of the winners of this last investment paradigm from from asset light to capital intensive, so potentially underming a vital strut of their attraction. Infrastructure businesses have a very different cash flow profile of course. The usual is for years and years of negative cash flows but payback later, usually a function of pricing power from a monopolistic position, or position in a regulated sector. In the regulated areas, you get governments stepping in to restrict that pricing power and make sure you earn your cost of capital and not much more. This time, the infrastructure build out is occurring in a highly competitive, unregulated space. This creates the risks of significant disappointment for perhaps a few of the players. So far, the related debt loading is reasonably contained, however this is something to watch carefully for.

All in all, stay calm. It is clear that under the surface of the major indices, particularly in the US, there are pockets of exuberance. At index levels, valuations are high but not yet asphyxiating. Meanwhile the number of daily warnings of a bubble are inconsistent with the wider spread intoxication that we associate with the great bubbles of the past. Besides which there are still plenty of scenarios were this incoming batch of technologies deliver on their promise and more. As in the past, beware assuming that all price surges are bubbles. That is often not the case – the industrial revolution in our midst does promise genuine transformation (again).

<sup>1. Goetzmann, William N (October 2015) Bubble Investing: Learning from History. National Bureau of Economic Research
2. Dimson, E., Marsh, P., & Staunton, M., 2009. Triumph of the optimists: 101 years of global investment returns. Princeton: Princeton University Press.
3. https://www.ai-supremacy.com/p/how-the-ai-bubble-compares-to-history-infrastructure-datacenter-lessons
4. Perez, Carlotta (2003) – Technological Revolutions and Financial Capital – The Dynamics of Bubbles and Golden Ages – Edward Elgar Publishing.</sup>