Are We in a Tech Bubble? Yes, and it's Crazier than 1999. When Will it Crash?
by Andrew Alexander
The views represented in this article are solely those of the author and may not be construed as in any way representative of the views or policies of Oxford Royale Summer Schools.
These are cynical times.
By Oscar Wilde’s famous definition, a cynic knows the price of everything and value of nothing. The same is true of the financial markets at present. Every market has two features: pricing and valuation. Pricing is the market output: what it produces each day in respect of the securities or commodities being traded. Value is the function of the market: it consists in finding the relative value of the underlying security or commodity, which is expressed by the pricing function so as to make it translatable in terms of other securities traded on other markets. Recently, the two appear to have become disconnected. While the market tickers continue to pour out a trickle of higher prices, these prices no longer seem to have any basis in a rational, plausible valuation. The markets have, simply put, stopped working, their failure to function a deliberate result of the academic capture of the world’s treasuries and the continued belief shared by all those in positions of monetary policy influence that to suspending a symptom is the same as a cure.
[pullquote]To be clear, Quantitative Easing acted as an enormous transfer of wealth from the public (with cash holdings and cash wages) to the financial system (holding financial assets whose price is being inflated).[/pullquote]For a long time, I have argued that quantitative easing will cause immeasurable damage to the real economy by suspending the risk pricing mechanism of the markets. Losing this function is not a by-product of QE, it is its goal. By pushing down bond yields through buying up the market, and by creating a tie between bond market intervention and zero interest rates, effectively fining savers for holding cash deposits, the current monetary policy environment forces money into riskier assets in order to generate a return. In so doing, it pushes down the price of these assets to a point where it is below the risk premium that would usually be applied by any investor. The system has therefore institutionalised the mispricing of risk across asset classes in response to a crisis in American housing that showed how deadly this could be when it happened in just two classes (real estate, mortgage bonds).
Quantitiave Easing encourages malinvestment and inflates bubbles
The audacity (and the foolishness) of the path pursued by the Fed, the Bank of England, the BoJ et al was disguised by the banality and dishonesty of the language used to convey its impact to the wider public. To be clear – QE acted as an enormous transfer of wealth from the mass of the public (with cash holdings and cash wages) to the financial system (holding financial assets whose price is being inflated); the markets had zero incentive to set this out for the wider the public and have not done so.
The markets, for a long time, even fooled themselves. What has been striking about the last six months is the change in tone – very few commentators and fewer still bankers when spoken to in private make a case for stock market prices based on fundamentals. Instead, they acknowledge that the market is chasing its own tail, pushing up prices in stocks and property for want of somewhere else to turn. The basis for market participation has become the greater fool theory. In other words, every market participant believes the emperor is naked and that the prices of assets are not clothed in any justifiable rationale or growth story. However, every market participant also seems to believe that every other actor believes the emperor to be fully clothed, trusting in the central bank narrative of recovery and non-inflationary QE. As a result, we are in the odd situation whereby the market price has zero credibility and yet everyone is a buyer. Such is the strange, post-QE financial universe we inhabit.
The new tech bubble
This is particularly true of internet stocks. The sixth most visited online clothes retailer in the UK has just floated. In a market with a dominant online only presence (ASOS) and several high street competitors with established brand names, a richer, more mature customer base, and the facility to visit shops and try on the sizing, BooHoo would appear to have an uphill battle to face for market dominance, particularly given the fickle and fluid world of online fashion, which leaves it, an established player, vulnerable to disruptive new entrants.
The markets didn’t see it quite that way. As the team at FT Alphaville calculated, profits less interest and tax for the last twelve months are probably around the £8.5m mark. The market capitalisation at one point on Friday was £850m, a multiple of 100x earnings. In the meantime, full year sales look to be around £103m, giving a market capitalisation to turnover ratio of 8:1, an astonishing outcome for any retail business. The market capitalisation is around the same as Debenhams, a household name with a multi-city retail operation, a strong online presence and an established dividend. Debenhams trades on a little over seven times earnings.
If the markets suspending their traditional scepticism of a non-luxury clothing float was one thing, the scramble for AO.com shares was quite another. Selling white goods – a notoriously low margin enterprise – AO has managed to achieve a valuation that sits at six times sales and apparently prices in the likelihood that the company will soon own the entirety of the British domestic appliance market. In contrast, Dixons, the UK’s largest retailer of household appliances, is valued at only 0.26 times earnings, the FT reports, despite having a stronger online growth profile than the newly floated AO.
Enthusiasm for Tech stocks as not been limited to the UK – in the United States, 2013 saw more Tech IPOs than in any year since 2000, and 2012 saw the highest value of IPOs in the space than at any time since the last dot-com bubble burst in 1999. In the M&A space, average deal value soared 65% in 2014, while virtual currencies like Bitcoin trade up to $1,000 a unit despite having no assets behind them and the CEO of Facebook is crowing about the bargain capture, for $19bn, of an application that makes no profit at a rate of $42 per user. In short, it is internet stocks that are exhibiting the most extreme examples of the price-valuation dissociation that has swept the market as a whole.
When will this tech bubble burst?
In my view, the valuation of internet stocks is a key bellwether for the health of the financial markets as a whole and has been for approaching two decades. This is not purely for symbolic reasons, but the symbolic reasons are worth commenting on. The most over-used analogy in the financial world is that of central bankers and the punchbowl, with Mark Carney and friends charged with providing enough lubrication to get the party started, but not so much that the markets lose all inhibition. Well, by this measure the central bankers have failed. The markets are roaring drunk, and they are exhibiting three major traits of a drunkard. The first is an inability to recognise the imbalance between the marginal benefit of each drink consumed in relation to the price paid the next morning. The second is the belief of each market participant that he or she possesses a special insight into the mysteries of the universe that eludes their peers. The final one is that like a drunkard, the markets have forgotten – they have forgotten about the dot-com crash and the filleting of paper valuations for digital businesses which were fundamentally incapable of generating profit. A decade and a half has passed and we are back in the same place. The two crashes have taught the markets nothing; they exist only in an abstract sense as curious historical vignettes and not warnings felt in present decision making.
Aside from the symbolic significance of the markets partying like its 1998, what lessons do dot com valuations lay bare for us? The first is how desperate the markets are to find an investment of any sort which will offer a real return into the future. This may seem an odd thing to say – surely a company trading on 100x earnings is not a growth stock? Let’s approach the problem from a different angle. Internet businesses still have about them a vague sense of the future, of a different world to this one. Investors look at conventional businesses, analyse past growth rates and returns, and they know that the price that the market is asking is ridiculous. Internet stocks do not have such data to critique, because they have never made a profit, because they have only recently come to market, because they operate in a market currently closed off to 70% of the people of the world: it is impossible to analyse them in these terms – investors only suspect that performance will lag valuation; they cannot be certain. As such, the very opaqueness of the investment becomes a prime reason to buy.
The second trend which internet stocks set out is the importance of narrative. The narrative around internet stocks is the same as in the late 1990s – they are poised for explosive growth, will shortly turn a profit, and will destroy luddite high street traders. This is one of a number of sub-narratives which sits under the great financial narrative of our times – that central banks are able to determine market outcomes without distorting the market’s ability to efficiently allocate capital and without consequences to the real economy. Almost all of these narratives are demonstrably untrue and, in fact, take a wilful effort to suspend disbelief. This is particularly true of the internet narrative. In developed markets, the internet is not the coming force; it has arrived. The vast majority of European and North American homes have access to high-speed browsing and hassle-free internet shopping and have done for ten years – there simply is not going to be the exponential rush of online customers businesses such as AO.com need to justify their valuations. Businesses like Twitter are mature, scaled and part of public life, and they still can’t make money. Most market participants know these things, just as most know that central bank interventions are creating dangerous distortions, yet their belief that they can ride the narrative and game the system exceeds their ability to reject something they know to be untrue.
Finally, internet stocks underline the arbitrary nature of the market and its divorce from fundamentals. If a significant online presence was a fundamental with an extremely high correlation with profitability, then newspaper stocks in Britain would be through the roof, as these draw huge amounts of traffic and have established online identities. This has not happened, largely because the stocks concerned are associated with old media and a slow-death narrative, rather than new-media and an explosive growth narrative, yet if internet exposure were valuable as a business tool in and of itself, rather than as a narrative peculiarity, then this would translate into similar valuations across stocks with similar internet exposures. Again, the irrationality of the segment is key to demonstrating the fundamental irrationality of the market.
Inefficient markets damage us all. When the ability of markets to assess value breaks down, so does their ability to allocate capital. The vast amounts of capital being devoted to extremely marginal businesses that produce only intellectual property with an extremely ephemeral relevance to living standards is symptomatic of the unintended consequences that QE has brought about. It is tempting to think that a market constituted on this basis cannot survive for long, yet this one has lasted close on half a decade. Maybe the real message from the internet stock valuation rise since 2007 is not that disaster is at hand because we are close to a crash. Maybe, instead, it is that the crash may be many years away, that the pretence running through the market at present is supported by such a wall of vested interests that it can be kept up for many, many years. The impact of such a prolonged misallocation of resources will have a far more telling impact on living standards than any short-term crash in nominal asset prices. That is the real social damage of QE, and its impact will reverberate through the generations.