Investing Through A Bubble

Goldman’s Non-profitable Tech Index is approaching 250% year-over-year performance. (Twitter)


If statistics like this haven’t given cause for concern, the market should take a long hard look at itself. 

Yes I do understand why the stock market is at record highs and equities seem to be the only game in town. Yes I get the arguments of how difficult it is to value equities in this post pandemic world with all the pent up demand and fiscal stimulus sloshing around. Yes, I realise how markets change over time and today, at least in the US,  they are dominated by low capital, highly scalable businesses. Yes I understand the mantra of ‘stonks only go up!’.


But something has got to give. They are companies trading today at crazy valuations. They are trading on sales multiples. Scratch that they are trading at some mystical TAM figure. To see how  dangerous this could be, have a look at what the  sun microsystems CEO had to say during the dotcom bubble:


“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”


I want you to read that again. And re-read it so you understand how crazy investing on high sales multiples is.


With this in mind it is easy to understand why people say  We Are In A Bubble. Now don’t get me wrong, not everything is trading at frothy valuations. You can argue that the FANG stocks are cheap as compared to the rest of the market and can also argue high quality UK listed shares  are in bargain territory.


Saying certain parts of the market is in a bubble is the easy. The harder part is knowing when the bubble pops. Have a look at the following excerpt by a piece written by Ahmed Elbakari, Tom Macky, and Igor Vasilachi:


“The S&P 500 index soared 38% in 1995. This sharp increase, following four years of steady gains, made some of the smartest investors on Wall Street begin to grow wary of a bubble in the making.

“I think we’re approaching a blow-off phase of the U.S. stock market,” Ray Dalio told Pension & Investments in 1995. “Price acceleration on the upside is preceding a significant correction—20% beginning over the next 18 months.” Peter Lynch echoed Dalio’s concerns in an article in Worth Magazine in 1995, warning that “not enough investors are worried.”


It didn’t take long for more of the world’s top investors to start worrying along with Dalio and Lynch. In 1996, the S&P 500 soared another 23%, defying Dalio’s predictions of a quick correction. Describing the frenzied stock trading in 1996, Howard Marks wrote, “Every cocktail party guest and cab driver just wants to talk about hot stocks and funds.” And in his end-of-year letter, Seth Klarman expressed his concern with the public obsession with owning mutual funds and internet stocks: “We know the current mania will end badly; we do not know when.”


But US stocks continued their upward trajectory, with the NASDAQ rising 22% and the S&P 500 rising a whopping 33% in 1997. George Soros had seen enough, persuaded by the same fact pattern Lynch, Dalio, Marks, and Klarman had all observed. He decided to put on a significant short trade against US technology stocks.


By the end of 1998, Soros had lost $700m betting against internet firms, the fledgling titans of the new industrial revolution. Quantum, the flagship fund of the world’s biggest hedge fund investment group, was suffering its worst ever year after a wrong call that the “internet bubble” was about to burst. Instead, companies such as and Yahoo! rose to all-time highs in April. Shawn Pattison, a group spokesman of Soros’s fund, said: “We called the bursting of the internet bubble too early.”


In the five years from 1994 to 1999, the NASDAQ returned about 40% per year. The type of value investing practiced by greats like Howard Marks and Seth Klarman had been left in the dust, with annualized returns for the large-cap value index of only 24%. Warren Buffett’s Berkshire Hathaway had lagged the NASDAQ by 15% per year since 1994, forcing Buffett to explain why he didn’t hold AOL, Yahoo!, or any of the other hot technology names. He told CNN in 1999 that he “can’t ‘see’ what technology businesses will look like in 10 years or who the market leaders will be.”

The broader public didn’t share Buffett’s concerns. In 1999 and 2000, there were 819 IPOs, day trading became a hot activity, and the NASDAQ rose 86% in 1999 and another 15% in the first months of 2000.


But in March 2000, five years after Dalio and Lynch first warned of a bubble, the NASDAQ turned a corner. What started with an announcement of rising interest rates by then Fed chairman Alan Greenspan—raising serious questions about the dot-com darlings’ valuations and ability to repay debt—trickled into a market selloff, scandals of bad accounting practices, and major bankruptcies. By October 2002, the NASDAQ had fallen 75% from its peak, giving up all of its gains in the bubble and returning the index to 1996 levels.


Dalio, Lynch, Marks, Klarman, Soros, and Buffett had all spotted the bubble and warned investors of the dangers. But their foresight came too early. From 1995 until the peak in 2000, investors who favored international stocks, value stocks, bonds, or commodities had all lagged the NASDAQ by more than 20% per year.”

Investing is hard. Even the best in the business, who called it right, were wrong for over 4 years and underperformed as a result! The trouble is one person’s bubble is another’s bull market and profit opportunity.


So even if we read that we are in a bubble today, no one knows when the party will stop. The most mainstream argument for a new bear market is rises in interest rates. But are you smart enough to guess when that will happen? At present your guess is as good as mine. It could be later this year. It could be in a few years. It could take longer. A lot of damage has been done to the global economy and it is unclear how quickly it can recover for central banks to even consider raising rates. Yes inflation could force them to do so but that’s for a whole other post.



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