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In this post, I’ll be explaining ‘The 2020 Tech Stock Bubble’ crisis, through the lens of the Dot com bubble of the 90’s. In the process, I’ll also provide educational content on technically spotting a bubble through different phases.
What is a Financial Bubble? A bubble is said to have formed when equity prices rise significantly, far beyond their proper valuation, in a short period of time. Bubbles are intangible and hard to spot, but their existence is undeniable, and hard to ignore. As such, it’s important for traders and investors to manage their risk before the bubble bursts.
What is the Dot-com Bubble? - The Dot-com Bubble, also known as the Internet Technology Bubble, was a rapid rise in US tech stock equity valuations fueled by retail and institutional investments in internet based companies during the late 90s. - During this bubble, we saw an exponential move in the market, in which the Nasdaq index rose from under 1,000 to over 5,000 within 5 years. - The Dot-com Bubble grew out of a combination of speculation: investing in internet tech-stocks at the time was the typical get-rich-quick scheme, as there were huge venture capital funds ready to be spent on startups with minimal substance. - Capital flew into those companies, in hopes that they’d be profitable one day, and these investments were done in an extremely bold manner, with retail investors and institutional investors both looking to maximize profits on a speculative basis.
What are we seeing today? - The market we are seeing today is not moved by investors who are looking at the long term prospect of the company. The Nasdaq Index overextending well above the 20 Simple Moving Average (SMA) on the monthly demonstrates that the market is driven primarily by momentum. - After the strong ‘V shape’ recovery we witnessed from the Corona Virus (COVID-19) stock market crash, people are trying to expose themselves to the financial market with the wrong mindset- chasing the next big thing, that will make them rich quick. The general public is trying to speculate where all the money is flowing into, and they arrive at one conclusion: tech stocks. - As such, it could be said that on a bigger picture, the market’s characteristics we see today are very similar to that of the Dot-com bubble. With a clearly bullish market trend, the number of new investors who are introduced into the market increase by the day, and with the profits they witness through growth stocks (and tech stocks in particular), 30% gains in a day has become a new norm for them.
However, this does not indicate that one should liquidate all their assets, and cash out before the bubble bursts.
Counterarguments 1. Introduction of liquidity by the Fed The Federal Reserve has been printing money at an unprecedented rate in order to rescue the economy from the Coronavirus pandemic. As such, it’s only logical that the stock market rises at least as the same pace at which money is being supplied. The Fed’s approach towards money supply is completely different from that of the 2000’s, which is why comparing the current tech-driven bull market to the Dot-com bubble is an incorrect analogy.
2. Momentum Relating to the reason above, it could be said that momentum was introduced to the market trend ever since the Fed started actively intervening in the economy. They decided to leave the interest rates near zero, at least until 2023, which indicates that momentum could continue throughout for years.
3. Fundamentals of Tech Stocks Unlike companies of the Dot-com bubble, tech companies today demonstrate some value and substance. Amazon (AMZN) is one of the few companies that survived the Dot-com bubble burst, and later grew to become a multibillion dollar conglomerate. Arguably a tech stock, Tesla Motors (TSLA) has also shown incredible performance in their financials over the past few quarters, demonstrating substance in their rise in stock prices. Whether the current valuation of the tech giants leading the Nasdaq index today is another question. One thing that’s very clear is that with the 4th Industrial Revolution, companies in the tech field show unprecedented rates of growth and innovation, which could justify the current bull market.
How to Spot a Bubble Spotting a bubble is extremely difficult, if not, impossible. Most people weren’t aware of the Dot-com bubble until they later thought about it in retrospect. However, referencing Hyman Minsky and Charles Kindleberger’s work can help us understand the structure of a bubble, and the characteristics of the market in each phase
1. Displacement Bubbles star with a shock to the system. They could be events like war, political change, technological innovation, or the introduction of a new monetary policy. A displacement creates a new opportunity for a sector of the economy, and in this case, it’s technology.
2. Boom A boom begins as optimism grows. A positive feedback loop leads to greater investment, which then leads to economic growth. Borrowers increasingly become more willing to take on debt and risk.
3. Euphoria Participants expect prices to increase at unsustainable rates, and even with a small number of people realizing there is a bubble, they continue to participate in the market thinking that they can load their assets to someone else before the market bursts. The general public begins to enter the market as media attention grows, and as individuals see their friends and acquaintances get rich. This is the phase of irrational exuberance.
4. Distress At some point, an event that causes a decline in confidence takes place. Depending on each bubble, panic can set in immediately, or could take several years to fully develop.
5. Panic When a crisis takes place, most people don’t even realize that it’s happening. Insiders and institutional investors are usually the ones to sell first. Panic is introduced into the market at retail investors all attempt to sell at the same time. This sell-off caused by panic continues until investors are convinced that cash will be made available to meet demand, leading investors to buy back in.
Conclusion Despite the current stock market index highly resembling that of the Dot-com bubble era, we also have to take into account the fact that many factors that fundamentally affect the stock market have changed. Also, considering that the Dot-com bubble lasted almost 5 years, even if we could confirm that the current market trend is a bubble, it does not necessarily indicate that the bubble will burst immediately. While it’s difficult to have patience, and suppress the urge to sell at the peak, buy back in when the market bottoms, investors should realize that there is still a lot of capital that could potentially flow into the market. As such, in lieu of trying to time the top, they should be focused on the market trend’s momentum, and execute their orders based on the confirmations provided by the market.
On Liquidity, what's your point of view on the massive retail investment into passive indexation and what it does to liquidity. As long as there is an influx of investment via 401k and people stashing away earnings, it should actually hold up prices especially of indexed equities and bonds quite nicely. But the continued slump in the economy, although adds strength to tech which is well positioned, will shave off employment and incomes in other sectors. So that means those incomes will slow down the amount of investment going into those passive funds, lowering liquidity. However, most people will not withdraw investments into passive instruments, they probably don't even watch the market. I've heard that something like 90% of transactions are coming from passive funds right now (although only about 30% of value).
What happens when those transactions get reduced and suddenly there is lower liquidity and a lot more supply than demand? Can the Fed make up for that? I'm probably very flawed in my thinking, so wondered your thoughts?
On the tech giants, I don't think they had bad fundamentals in the dotcom bubble. It was the high valuations of startups burning cash on bad business models. I don't see as much of that anymore. Tesla has a great model, just needs to continue to innovate. Zoom is overpriced because of the market, not because of bad fundamentals. The issue with the valuation of big giants ties back to the passive indexing again. There is no price discovery when money flows through a passive fund. The money comes in and the fund buys based on the weighted market value of the companies in the index. So who cares what AAPL is really worth, just make the purchase, driving up demand, driving up volume, driving up the price. What happens when that goes away and you want to sell AAPL with no buyers?
So I don't think we are in a dotcom bubble, based on greedy investors pushing up valuations. But I do think there are some very fragile, unchartered (can't learn from historical analysis), structures to the current market. I'm happy to keep taking the Feds money, I sure have given them a lot of it. But I wonder how long this can go on.
drewby4321
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@drewby4321, Also I'm curious what is the data source for the Smart Money chart?