Technology Bubble (1996-2000) vs. Financial Bubble (2003-?) (Part I)

Many bloggers, journalists, and authors have equated the current Financial Liquidity bubble with the Technology bubble of the late 1990's.  The Tech bubble was defined by the internet or "dot-com" stocks that rose and fell during the late 1990's and early 2000's.  The Financial Bubble is defined more by the rise of financial derivatives and institutions but involves the entire economy and markets much more so than the Tech Bubble ever did.  Some will argue that our current situation it is not a bubble and that we are just spreading risk around the system more efficiently.  The people who understand risk know that risk has been spread around the system – dampening volatility.  These people will not, however, agree that this negates the possibility of a bubble.  Risk transfer is risk TRANSFER and nothing else.  It is NOT risk reduction.  For every hedge bought there is someone on the other side of the trade, and behind every "hedged" position there is a model filled with biases and probability distribution approximations.  The only risk worth hedging at this point is the one that everyone is wrong.  Without getting into global liquidity, derivatives, and all the other topics that have been beaten to death, let's review how this bubble relates to the Dot-Com mania.

 

Theory

Both the tech bubble and the financial bubble have been dominated by theorists and theories.  The tech bubble, at its roots, was grounded in the theory of Moore's Law – that the processing capability of chips would double every 18 months.  People took this to believe that the internet and its companies would grow at the same rate as well.  People believed that these companies were immune to systematic economic risks such as recession, and well – bubbles.  When this turned out not to be the case, people realized that they were foolish and shares sold off sharply and the bubble was popped. 

The financial bubble has been dominated by Globalization theory.  This is a hodgepodge of different economic, social, and political views.  Thomas Friedman (The Lexus and the Olive Tree, The World is Flat), a pioneer in the movement describes the basis:

"... not static, but a dynamic ongoing process: globalization involves the inexorable integration of markets, nation-states, and technologies to a degree never witnessed before--in a way that is enabling individuals, corporations, and nation-states to reach around the world farther, faster, deeper, and cheaper than ever before, and in a way that is also producing a powerful backlash from those brutalized or left behind by this new system. ...The driving idea behind globalization is free-market capitalism--the more you let market forces rule and the more you open your economy to free trade and competition, the more efficient and flourishing your economy will be. Globalization means the spread of free-market capitalism to virtually every country in the world. Globalization also has its own set of economic rules--rules that revolve around opening, deregulating and privatizing your economy"

-Thomas Friedman, The Lexus and the Olive Tree

Although I agree with many of the ideas behind Globalization, I do not believe that we have gotten it right.  The spreading of risk and the openness of government along with the idea of a positive sum game has led to a credit crisis and huge global imbalance. 

The Global Economy is an unchartered territory, with many surprises in store for those that think they have the map.  If you were to ask the owner of Pets.com at the height of the dot-com boom if he believed that they were in a "New Economy", ripe for returns, he would have unequivocally said "Yes."  The pundits that you see on TV are no different.   It will be interesting to see what the headlines for this bubble and its underlying "pioneers" will be when the time comes. 

 

(mis) Valuations

Back in the Dot-Com days, stock market valuation was defined by a few concepts.  First, was the aforementioned Moore's Law that the internet growth would double every 1.5 years.  This allowed for universal incredible growth rates and the false predictions that revenues equaled profits.  Speaking of revenues, the second characteristic of this market was that a "Dot-com" should be valued by sales.  Although the "burn rate" for these stocks was high at first, they were all assumed to eventually turn a profit and inhabit the great "Castle-in-the-sky".   This led to the philosophy of "get big fast" if a company could gain enough market share profits would come.  What was seen is that the revenues didn't turn into profits, market share was only captured by the few, and most companies were worthless.  The major mis-valuation was the idea that top line growth would move to the bottom line. 

The Financial Bubble's mis-valuations are much more subtle.  As mentioned earlier – this is not a bubble that has been contained within the sector (although the tech was not either).  This bubble is the idea that capital markets are much more efficient, interest rates can remain low, inflation inexistent fueling prosperity, consumption, and investment.   Just as the internet bubble involved the over-estimation of the growth of the internet, the financial bubble involves the over-estimation of future economic and earnings growth.  There are a slew of issues that lead to this rosy forecast.  I will touch on a few:

1. Basis on past data.  Relative valuations and earnings growth estimates are based on past history.  When an analyst on CNBC speaks that companies are historically undervalued at 17x earnings, he is using the data that INCLUDES the prior overvaluation.  This exerts an upward bias on expectations and has fueled pressure on Central Bankers to create an environment where it exists.  The belief that earnings are going to grow at 10% + continuously is naïve and short-sighted. 
2. Central Banks and the Financial System are much more efficient at managing risks in the global economy.  I will concede that they have gotten better at managing the risks that occurred in the past, but that says nothing of what may occur in the future.  They also have not been managing risks as much as delaying them.  Remember, the Fed bailed out LTC in 1998, and Greenspan bailed out the U.S. economy in 2002-2003 – slashing rates to nearly zero.  Many risks exist and are very real.  The Fed has little control over most of them except for  checkbook and a printing press (both of which may not work the next time)
3. Overstatement of Equity Risk Premium/Long Run average returns – The equity risk premium has been overstated for years.  The truth is if everyone belies that stocks are going to return on average 10% a year (it used to be 7%) as in Siegel's Stocks for the Long Run, then they in theory erode away much of that premium as they buy what they deem as a "risk free asset" – causing equity returns to fill in for Bond returns in the CAPM equation.  This is referred to as the "Equity Premium Puzzle."
4. Over-leverage of the American Consumer.  Our companies' earnings are directly related to how much our consumers consume.  Years of easy money with little wage growth has caused enormous debt loads that will begin to affect their consumption habits.  This causes earnings and revenue growth to both be overestimated – explaining the attractive valuations.
5. Ignoring the demographics – It is no coincidence that the largest demographic shift experienced their most productive years during our historic bull market.  Demographics can explain much of the growth that occurred, and will be attributable to much of the slowdown to come.  The next 10 + years will bring many problems as the government will be forced to deal with many of the social entitlements that their voting block expects.  This could dampen economic activity and earnings growth.   
6. Hedge Funds eliminate/soak up risk – Not too sure whether this is true or not.  All it would take was some correlations to emerge that never existed or some Black Swan event to prove this wrong.  Since we can't see what they are sitting on there is a risk inherent in that anyways. 

Although the Tech Bubble was characterized by much more glaring overvaluation, when compared on a future earnings basis – both are very overvalued.  Taking inflation into account – things haven't been rosy for some time.

 

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