Our view is that the market constantly creates single-asset micro-bubbles, isolated examples of extreme mispricing which require severe right-tail outcomes to justify the asset’s price. Over the first quarter of 2018, Tesla has been an excellent example of a micro-bubble. Tesla’s current price is arguably fair if most cars are powered by electricity in 10 years, if most of these cars are made by Tesla, if Tesla can make those cars with sufficient margin and quality control and can service the cars properly, and if Tesla can raise additional capital sufficient to cover a $3 billion annual cash drain and another billion to service its debt. To us, that seems an unduly optimistic array of assumptions, especially given the magnitude of Tesla’s debt burden. Such an argument ignores the deep pockets of competitors and the common phenomenon of disruptors being themselves disrupted by newcomers. Absent the unfolding of this rosy scenario, Tesla’s current price would require remarkably aggressive assumptions to deliver a positive risk premium. For investors who agree with this assessment, Tesla constitutes a single-stock micro-bubble.3 This example also illustrates a key point about bubbles: Because the current price is acceptable to the marginal buyer and seller, there will always be a cohort that says, “This is no bubble!”
Sector and broad market bubbles are much rarer events. In this context, a bubble occurs in a sector or a market for which an implausible set of circumstances must prevail in order for the sector or market to collectively deliver a positive risk premium relative to bonds or cash, even though sufficiently aggressive assumptions could realistically occur to justify any single stock’s price.
The 1999–2000 tech, or dot-com, bubble is the poster child for a broad market bubble. At the height of the bubble, aggressive assumptions were required to believe the entire US stock market would deliver a positive risk premium relative to then-prevailing bond and cash yields (Arnott and Ryan, 2001). For the tech sector, in particular, to deliver a positive risk premium compared to the 6% bond yield at that time, most tech stocks would have had to produce rapid growth far into the future, even though few could have succeeded unless their fiercest competitors were struggling. In hindsight, using our simple definition, the tech bubble was indeed a bubble. More importantly, many observers in the midst of the bubble correctly perceived it for what it was (Asness, 2000).
At the beginning of 2000, the 10 largest market-cap tech stocks in the United States, collectively representing a 25% share of the S&P 500 Index—Microsoft, Cisco, Intel, IBM, AOL, Oracle, Dell, Sun, Qualcomm, and HP—did not live up to the excessively optimistic expectations. Over the next 18 years, not a single one beat the market: five produced positive returns, averaging 3.2% a year compounded, far lower than the market return, and two failed outright. Of the five that produced negative returns, the average outcome was a loss of 7.2% a year, or 12.6% a year less than the S&P 500.
Eerily similar to the “new economy” dogma of the dot-com bubble is today’s cryptocurrency craze. It boggles the imagination to hear people speaking of “investing” in bitcoin, an electronic entity that offers no hope of future operating profits or dividends, is little used as a surrogate for money in transactions (trading volume is well over 100 times as large as spending volume), offers an uncertain longer-term use case, and has no objective basis to determine fundamental value. Will bitcoin and a handful of other cryptocurrencies settle in and become a stable store of value, akin to gold or sovereign currencies? Perhaps. Those of us who are libertarians, wary of government control of the money supply, are rooting for that outcome. That said, how many investors are holding cryptocurrencies for any purpose other than the expectation that someone else will pay a higher price at some point in the future?
Arguments for the future value of cryptocurrencies bring back fond memories of the “price-to-eyeballs” metrics used to justify the market cap of businesses such as Pets.com. Nonetheless, the price of bitcoin rose by 1,369% in 2017.4 Even if we assume that bitcoin has merit as a libertarian alternative to government-sourced fiat currency, it’s hard to justify today’s 1,500 different cryptocurrencies. Many of these were launched with the singular goal of making the originator of the cryptocurrency wildly wealthy in an ICO (initial coin offering).
It’s harder still to justify the myriad exchanges, which offer only a receipt indicating the purchaser owns cryptocurrencies on their platform, many of which have been hacked, costing customers billions. As for the platforms that offer lofty interest rates to those who lend them cryptocurrency, little doubt exists many of these operators intend to convert your cryptocurrency into their own “kleptocurrency.” And now, bitcoin futures permit leveraged investments in one of the most volatile “assets” ever created.
The speculative nature of the cryptocraze cements, in our minds, its bubble status. Anecdotal stories abound of individuals looking for a once-in-a-lifetime opportunity to get ahead or to rescue their severely underfunded retirement plans (Harlan, 2018), buying cryptocurrencies because they are driven by a fear of missing out (Aslam, 2018), and paying prices only justified by extrapolating wildly positive price trends. A recent survey of fintech leaders, certainly a biased sample but the group likely most heavily involved in trading cryptocurrencies, forecast returns for calendar year 2018 ranging from 95% to 2,920% for the top 10 cryptocurrencies.5 Pity the unlucky investor who selects the only cryptocurrency that fails to even double in value!
The bitcoin bubble also serves as a wonderful example of how bubbles create harmful distortions in the real economy. The website Digiconomist estimates the run-rate annual electricity utilization of the bitcoin network at 56 billion kilowatt-hours. That’s more than enough to power all the households in Los Angeles for a year, and nearly enough to meet all of Israel’s power demands. Bitcoin already consumes about 0.25% of total global electricity consumption! All just to “produce” new coins on a nonphysical ledger and move these coins around on electronic exchanges.6 Will we someday find that all of this energy consumption has gone to waste?7
We see a bubble in the US stock market today, albeit less extravagant than Tesla or the growing swarm of cryptocurrencies. Reasonable observers can disagree, but we believe we are experiencing a tech bubble, based on our relatively rigorous definition of the term.8 At the end of January 2018, the seven largest-cap stocks in the world were all tech fliers: Alphabet, Apple, Microsoft, Facebook, Amazon, Tencent, and Alibaba. Never before has any sector so dominated the global roster of largest market-cap companies. At the peak of the tech boom, four of the top seven companies by market cap were in the tech sector, and at the peak of the oil bubble, five of the top seven were in the energy sector. Only the Japanese stock market’s bubble at yearend 1989 has matched today’s tech sector dominance of the global market-capitalization league tables.9 Not only do we have the FANGs, we have FANG+ futures, affording investors a chance to buy the world’s trendiest tech stocks with almost no collateral, and the list is amended quarterly to make sure only the trendiest are on the list.
History shows that, on average, just two stocks from the global market-cap top 10 list remain on the list a decade later. The two survivors almost always include the number-one stock. But the number-one stock has never been top dog a decade later, ultimately underperforming and moving lower in the list. The second surviving stock has 50/50 odds of beating the market. If this history repeats, nine of the top 10 market-cap stocks will underperform the market over the next 10 years, and just one has a 50% chance of underperforming. We don’t particularly like those 95% odds.
Can all of the seven tech highfliers collectively succeed to sufficiently justify their $4.3 trillion combined market capitalization at yearend 2017? Nothing is impossible, but this outcome is implausible. Sure, some of the new tech giants are at valuation multiples that are not extravagant, but several sport startling multiples—and alltrade at levels that require robust continued growth. These companies are at war—in some cases directly with one another—for market share, competing for the same eyeballs, and are facing a growing risk of regulatory constraints. If history is a useful guide, Apple may still be in the top 10 list (but no longer number one) in 2028, and perhaps one of the others will still be on the list. History would suggest that, of the seven, at least six will underperform the market over the next 10 years. Beyond the top-tier tech favorites, a host of companies such as Snap, Hubspot, Overstock, and now Shopify each have negative earnings and lofty price-to-sales ratios.
Not only are the market prices of most tech darlings far above reasonable valuation models, investors are overwhelmingly positive and projecting high future returns. Consider some of the investor sentiment measures described by Greenwood and Shleifer (2013). The Wells Fargo/Gallup Investor and Retirement Optimism Index sits at its highest level in 17 years, and 49% of respondents (also an all-time high) indicate either “a great deal” or “quite a lot” of confidence in the stock market as a place to invest. The American Association of Individual Investors investor sentiment survey began calendar year 2018 with 59.8% of respondents bullish on the stock market, the highest level in seven years, and a mere 15.6% registering a bearish opinion. The University of Michigan’s Index of Consumer Sentiment now shows an all-time record for favorable assessments of current economic conditions. The Graham–Harvey survey indicates that US CFOs are showing the highest level of optimism ever recorded in the survey’s history, even though the CFOs’ average return expectation for the S&P 500 of 6.6% for 2018 is not extravagant.
We see evidence of bubble behavior in other markets as well.
- Consider the inverse VIX ETFs that allow investors to bet against volatility. In late 2017, the Wall Street Journal published an article that explained how an entirely plausible rise in volatility would be enough to wipe out these funds. Yet investors continued to underappreciate the risk inherent in such strategies, expecting low market volatility to persist, and shrugged off the completely credible “wipe out” scenarios. The money continued to pour in. Just weeks after the Journal’s warning, that exact scenario materialized, with the VIX more than tripling in a single day, wiping out several of the funds in early February 2018.
- Late in 2017, the yield on European junk bonds fell below 2% and below the yield of the 10-year US Treasury bond. In order to justify this remarkable event, we would have to expect a decade of sustained dollar weakness relative to the euro. But it seems that European investors, either because of home-country bias or because of restrictions on foreign holdings, have been so desperate for yield they have priced European junk bonds at levels that more or less assure a negative risk premium.
- At the same time, in late 2017, US junk bonds yielded materially less than emerging market (EM) sovereign debt. To be sure, EM debt is not immune to defaults (e.g., Venezuela and Argentina—several times for each), but the average default rate is less than half that of US junk bonds, especially when we adjust for recovery rates. EM currencies would have to tumble over the coming decade to justify this yield spread. Should we assume that the market is correctly pricing this bleak currency outlook or should we acknowledge that EM sovereign debt is likely to deliver a more positive risk premium than US junk bonds?