There is a lot in the news on the international front just at this moment. A civilian airliner has been shot down over Ukraine and the Israelis have invaded Gaza. I try to take a longer view in these posts so the specifics of either of these events is not my primary focus. But I was already thinking about both areas when I started thinking about the subject at hand.
These two currently red hot hotspots join a much longer list of merely hot hotspots. There is Syria, which merits two entries. There is the "chemical weapons" entry and the "ongoing civil war" entry. Iraq is breaking wide open. There is the "what to do about al Maliki" issue, the ISIS "Sunni eruption" issue (which can be linked to the "Syria civil war" entry), and the "what to do about the Kurds" issue. Iran too gets two entries; one for the "nuclear" negotiations and one for its participation in Syria/ISIS (and possibly Palestine support, which is related to the Gaza invasion issue). Then there is Afghanistan, which has just completed disputed elections and is the object of some sort of a U.S. military withdrawal. There are other hotspots on the International front but I think we now have a list that is plenty long enough.
One could find a number of commonalities in this list but the one I want to focus on is "negotiations". A hotspot will flare up and immediately someone, and frequently several some ones, will immediately call for negotiations. In more long run crises the periodic hew and cry for "negotiations" is a standard feature of their evolution.
The idea is simple: "jaw jaw is better than kill kill". If people are talking they are not shooting and if they are not shooting people are not dying. That's the theory anyhow. But negotiations don't seem to have a very good track record. The current Gaza situation is a classic example. I am going to skip the long and complicated history here and focus on just focus on the events of the last few days. Israel started bombing Gaza and threatened an invasion. The U.S. immediately popped up and made loud "negotiations" noises. Egypt jumped on the U.S. bandwagon and came up with a deal that the Israelis accepted. But then Hamas balked and the "deal" never happened. At a more micro level both sides agreed to a "5 hour" cease fire but the terms were widely violated. And at this hour the Israeli military is rooting around on the ground in Gaza. This is a particularly depressing example of negotiations failing but it is far from unique. What's going on here?
Several hundred years ago white settlers "negotiated" a sale of Manhattan Island from the local Indians for chump change. This is an example of a negotiation that went badly wrong for one side. But since then most people have gotten wise to how negotiation works. So you can still find situations where one side or the other gets taken to the cleaner but this now rarely happens. The art of negotiation has been an area of serious study for many decades now. You can read books or get degrees in how to conduct negotiations. So the chance of someone pulling off a coup against the other guys is very small these days. And the situation is actually worse. People have been "horse trading" for millennia. It is easy to find examples of disadvantaged people who do fine in a negotiation. Somehow or other they turn out to be to be good at it.
This was driven home to me many decades ago. It is another lesson from the U.S. experience in Vietnam. On one side you had smart sophisticated Americans. The U.S. team was led by Defense Secretary Robert McNamara. Before becoming Defense Secretary he had been President of Ford Motor Company. There he had cut his teeth negotiating with auto unions. So he knew a thing or two about negotiation. On the other side you had the North Vietnamese. North Vietnam was half of a third world country, for God sakes. On paper they stood no chance. The whole thing should have been a repeat of the Indians and the Dutch in Manhattan. But it wasn't. The North Vietnamese more than held their own at every stage of the years long negotiations. Beyond that I learned that negotiations don't get anywhere until both parties want them to get somewhere. The North Vietnamese in particular thought that they could win by continuing to do what they were doing outside the setting of the negotiations. This resulted in a comic situation. It took over two years to decide what the shape of the negotiating table would be. Would it be round, where all parties would be on an equal footing or would it be square so each party would have its own side. (It's been so long now I don't member what the final outcome was.)
My take away from this is that negotiations can't get you anywhere until all sides actually want to come to an agreement. Part and parcel of this is that what each side wants must be what the other parties are willing to let them have. The Vietnam negotiations did eventually come to a successful resolution. The North Vietnamese wanted the U.S. out of Vietnam and a negotiated "settlement" as a necessary condition for that to happen. The U.S. wanted to "declare victory and leave". A "successful" negotiation gave them the fig leaf they needed to pull this off. The other parties involved were too weak to affect the outcome. Ultimately, the North Vietnamese were right. Continuing to do what they were already doing eventually led to them winning the war. The U.S. had concluded but couldn't publicly say that the war effort was doomed to failure. The South Vietnamese held on long enough so that the U.S. could pretend that the U.S. withdrawal and the takeover of all of Vietnam by the North Vietnamese were two separate events. So in a "cut your losses" sense, the negotiations were ultimately a success for the U.S. too.
This left me with the belief that negotiations don't settle anything until the parties are ready for them to be settled. I expect negotiations to fail whenever I think that the underlying positions are still in conflict. If there is a formula then the parties can find it quickly. If there is no formula then nothing will come of negotiations. Having depressed you with a situation where the U.S. fared badly let me talk about a situation where things went surprisingly well. This is the whole "chemical weapons in Syria" issue.
It has long been known that Syria had large stockpiles of relatively modern chemical weapons and the military means to use them. When the whole Syrian revolution went hot a lot of people became seriously concerned. The concern was justified. At some point the Assad regime started actually using them. Previously President Obama had drawn a "red line" around the use of chemical weapons in Syria. The first evidence seemed to be pretty much small bore. Obama tried to hand wave this away in the reasonable belief that if he had to do something he didn't have any good options. This resulted in some criticism but it wasn't just the President that saw no good options. Then Assad launched a chemical attack that was big enough it couldn't practically be ignored. That put the fat in the fire.
Then, as Obama is weighing his many bad options, the idea was floated to do a deal where the weapons would be taken out of Syria and destroyed. In a remarkably short time a deal was struck and all of the known chemical weapons have since been removed from Syria. Any doubt about how good this news was got dispelled when ISIS declared a caliphate in eastern Syria and western Iraq. Assad rates high on the "bad guy"-o-meter. But ISIS rates an eleven. The world is a better place now that we don't have to worry about ISIS getting its hands on chemical weapons. It seems very likely that they would use them aggressively. Saddam used them in Iraq against the Kurds not that long ago in the same part of the world. So it is a very good thing that the weapons are gone. And it appears negotiations played a key role in making that happen. And that's true. But, having set up the background I want to talk about why they succeeded this time.
Chemical weapons were first used on a large scale in World War I. But the WWI experience taught two lessons: In the right circumstances they can kill a lot of people and they are very hard to control. So the "right circumstances" are much harder to come by when you most need them. Immediately after the end of the war various efforts were made to ban them. And they were not used to any extent in World War II. Now various horrific techniques were used: torpedoing of neutral ships, bombing of largely civilian targets (London, Berlin, Tokyo), extermination camps, firebombing, drone attacks, rocket attacks, and the Atomic Bomb. The case can be made that chemical weapons are no more horrific than these other techniques that were used. So why not use them too? The reason is this whole "control" thing. It is hard to make sure the large scale use of chemical weapons kills the bad guys without killing the good guys. All these other techniques could be much more easily controlled.
The modern fear industry does not talk about this when discussing chemical weapons. It would interfere with their ability to make us afraid of whatever they want us to be afraid of today. But the people involved in the negotiations were aware of this disadvantage. Both the U.S. and Russia saw advantage in being on the side of eliminating them. Assad was put under pressure from the Russians. But he also saw that he could be equally effective militarily without chemical weapons. And the other tools in his military toolbox did not carry the heavy propaganda cost of using chemical weapons. So he did not put up that much of a fight when the Russians pressured him. And ultimately everyone (Assad, the rebels, the U.S., the Russians, other less important players) cooperated to get the weapons removed under horrific wartime conditions.
Here we had a deal that everyone could sign on to and that everyone saw some personal benefit in being a party to it. Once all the parties figured this out the deal came together very quickly and has since been carried out. With this perspective in mind let me run down the list and see how things fit (or don't) in these other situations.
Ukraine - The Ukrainians have suffered from a spate of bad governments in the post-Soviet era. This resulted in Putin seeing an opportunity and engineering the annexation of the Crimea to Russia. Having succeeded there Putin fomented unrest in the eastern provinces of Ukraine, which contain large numbers of people who are culturally Russian. Incompetence and disorganization on the part of the current Ukrainian government contributed to a belief that he would be successful here too. But this annexation has not been going as smoothly as the Crimean one did. And now we have the latest event where a Malaysian civilian jetliner was shot down over the disputed territories. Over, above, around, and through all this have been various calls for negotiations. The official U.S. position on the "unrest" in eastern Ukraine is a call for negotiations between the current government of Ukraine, Russia, and possibly others.
I believe it is too soon to expect anything. But we may be close to the time to sit down and start taking. The Ukrainian government seems to be quickly getting its act together. The "rebels" started out with a lot of support from the local population and even more support from Russia. But they have played their hand badly. I see the Russian role as opportunist. Putin styles himself as a great Russian nationalist who is a champion of Russian interests. Annexing Crimea was a success because it was cheap in terms of both blood and treasure and was well received (for the most part) by the population involved. It definitely advanced the interests of Greater Russia - we are powerful and successful and we are the champion of Russian people wherever they are. But Ukraine is turning out to be a much more expensive proposition.
The Ukrainian government, after a number of early stumbles has started reacting effectively. And the shooting down of the airliner is a giant black eye. Russia has long been seen as a bully by its neighbors during the Putin era. Crimea, eastern Ukraine, and now especially the airliner shoot down feed that narrative. And if Russia is ultimately unsuccessful in annexing eastern Ukraine that is a blow to the whole "Greater Russia" narrative. It's not even necessary for the effort to fail. It is only necessary for important interests in Russia to decide it is likely to fail or to be too expensive, As a basically opportunist endeavor Russia will want a graceful exit as soon as they decide the whole thing is a bad idea. In the same way that the U.S. objectives changed in the Vietnam negotiations the Russian objectives will change in the eastern Ukraine negotiations. At that point successful negotiations become possible. I don't think we are there now but I think we could be soon.
Gaza - Here I expect failure into the foreseeable future. Hamas still thinks it can outlast Israel. For political reasons within the Arab world Hamas receives enough support so that they have the luxury of continuing to hold that position. Israel believes it is confronted with an existential crisis. They believe that if Hamas wins then Israel will cease to exist. These are incompatible positions. They have been firmly held on the Israeli side since the country came into existence in the late '40s. And the position has been supported by one Palestinian faction or another over the same period of time. That faction has always been powerful enough to veto any Palestinian peace initiative. Until this changes negotiations are doomed. I don't see this changing any time soon.
Syria - I have discussed the chemical weapons situation. Let me move on to the civil war. Here both sides see themselves in an existential situation. Until that changes I see no hope for negotiations. But unlike the Israeli/Palestinian situation, where nothing material has changed in decades, the Syrian situation is in flux. ISIS has a strong potential for upending the playing field. I believe that ISIS has a real possibility of creating a country consisting of eastern Syria and western Iraq. The current boundaries were drawn up by the British and French at the end of World War I. Then make no geographic or cultural sense. ISIS may cause some of those boundaries to be redrawn along lines that make much more sense geographically and culturally. The big barrier to ISIS success that I see is the question of whether ISIS can actually govern. This is hard to predict. But if they actually turn out to know how to govern then I think they have a real chance of creating a country. Whether it is a caliphate or not is a minor consideration. And its politics might not be what the west and the U.S. will prefer but that won't stop it from happening. Frankly, I don't know what the cultural map of Syria looks like if you slice the Sunni east out. So I don't know how an ISIS success will affect Syria. But there is too much in flux for negotiations to be worth the trouble at this time.
Iraq - Here I think my crystal ball is clearer. I think Iraq in its current form is doomed. The three main factions in Iraq are Sunni, Shiite, and Kurd. The Kurds have already signaled where they stand. They want their own country. The al Maliki government in Bagdad is too weak to stand in their way. Considering the alternatives the outside world may decide that an independent Kurdistan is better than the alternatives. It is up to the Shiites in Iraq to decide how important it is to do something about ISIS. I think the U.S. will have little influence on that decision. There is talk about replacing al Maliki with someone else. That was tried by the U.S. in South Vietnam. It didn't work then. I don't think it will work now especially given that no competitor has emerged so far. I think that the Shiites are stuck with al Maliki. One possible outcome is that the Shiites in Iraq will unite with the Shiites in Iran. I think this is an interesting possibility but unlikely. The Iraqi Shiites are Arabs. The Iranian Shiites are Persian. The Arabs and the Persians have been fighting for several millennia. I so no reason to believe it will stop any time soon. So what I see is a Shiite Iraq, a Sunni caliphate (for lack of a better term), and a Kurd Kurdistan. I think all this will happen relatively soon but not right now. So right now negotiations are a waste of time.
Iran - I have already covered the Iraq/Syria/ISIS issue. Let me move on to the nuclear negotiations. The "deadline" for talks to conclude has just been extended. This is a less than shocking development. Nuclear weapons share some similarities with chemical weapons. They are not that controllable. Sure, you can explode one exactly where you want. But they tend to be too big. And they are a propaganda disaster. The only benefit seems to be the prestige angle. "I am a big bad nuclear power who has to be accorded due respect." But several countries including Brazil and South Africa have decided they are more trouble than they are worth. Everybody assumes Israel has nuclear weapons but officially they won't admit it. Where's the prestige in being a nuclear power if you don't brag about being a nuclear power? And other countries seem to be willing to go after Israel anyway. So the prestige looks vastly overrated. Then there is North Korea. They are a nuclear power and everybody knows it. But they are still seen as a pipsqueak country. So North Korea represents another blow to the prestige argument.
What Iran says is that they want to be a nuclear power in the sense that they process nuclear fuel. Their official position is that they don't want a bomb. Some people think they are telling the truth about this and some people think they are lying. But either way it represents the basis for a deal. The U.S. and other western powers said they didn't want Iran processing nuclear fuel at all. But all the international treaties say it is OK for Iran to process fuel. The deal consists of Iran not making a bomb in exchange for Iran being allowed to have a heavily monitored nuclear fuel industry. I think that's a feasible deal. And I think there is enough prestige in being a fuel processor to make up for what ever prestige they miss out on by not being a nuclear power. So Iran gets the prestige they want. On the other side Iran gets to do what treaties already say it can do, namely process nuclear fuel. But that nuclear fuel industry ends up being heavily monitored. In short I think there is a deal to be had here. But there is also the art of the deal.
A deal must be sold to both sides. Going in each side promises its supporters that it will come away with more than it actually gets in the end. This has to be dealt with. The standard method is "we got as much as we could and the deal we got is better than no deal". The specifics of the deal (in this case the prestige for Iran of being a nuclear processor balanced against the fact that they are a heavily monitored one) is what you use to manage the second problem. The standard technique for handling the first problem is brinksmanship. First, you set up a "hard deadline". Then you go past the deadline. Then you reach a middle of the night deal after the deadline. It may be ugly but it works. I think there will be an Iranian nuclear deal along the lines outlined above. I think it is a "win/win" all around. But the western public has been promised that the Iranian nuclear capability will be wiped away completely and the Iranian public has been promised that the Iranian government will not be pushed around by the "running dog" west. Most Iranians probably don't want Iran to be a nuclear power but they also don't want their government to cave to the west. By going to the last minute and beyond each side can credibly argue that they got the best deal they could get. Without the drama and brinksmanship the argument is much harder to make. So I predict more brinksmanship but ultimately a deal.
Afghanistan - If I had my way the U.S. would be completely out of Afghanistan. Iraq is falling apart because the fissions in its society keep growing and there was no opposing force to shrink them. We have much the same situation in Afghanistan. The Northern Alliance represents Pashtuns but not the other components of Afghan society. There is rampant corruption coupled with bad government. This results in a classic "the center is not holding" situation. We need to get out of the way and let the Afghans sort this out. They need to figure out how to do this on their own. Otherwise they will never build the strong institutions necessary for long term success.
Then there is Pakistan. Pakistan has subsisted on blackmail from various foreign powers since it came into existence when the British relinquished control of India in the late '40s. The U.S., the Chinese, the Russians, the Saudis, and others have been pouring money into Pakistan at various times for various geostrategic reasons. Currently the U.S.'s reason is that Pakistan squats on the supply lifeline to our troops in Afghanistan. If we have no troops there then we have no reason to continue to pay the blackmail. Getting all of our troops out of Afghanistan gives us a much better position vis a vis Pakistan.
Getting all of our troops out of Afghanistan cleanly may not be possible. But our leverage in Afghanistan is weak. If we can do something about making sure the election was not rigged then so much the better. But that's about it. We should tread very carefully with respect to any commitment beyond the end of 2014.
Finally, let me return to the whole "talking is always better than fighting" argument for why negotiations are supposedly always a good idea. There is a cost to full tilt negotiation. You lean on one or both sides to try to lever concessions out of them. If the negotiations ultimately fail there is a cost associated with this kind of power diplomacy. We may have pressured one side into a concession that is no longer worth it after negotiations fail. But the concession may stay hung around their necks anyhow. And countries do not like to be leaned on any more than people do. They resent it. So strictly "going through the motions" calls for negotiations are probably OK because the costs are low and in line with the benefits ("we are pro-peace types"). But the kind of negotiations the U.S. has engaged in between Israel and Palestine have been full bore enough so that the costs of the ultimate failure may be significant.
I have very little good to say about George W. Bush. But I think he made the correct decision to not push hard for Israeli/Palestinian peace. It was not in the cards then. I don't think it is in the cards now. I salute George Mitchell and John Kerry for trying. But I think it is important that these efforts be realistic. If there is a deal to be had, great. Charge ahead full steam. But if the deal is not really there make sure that your efforts are not counterproductive.
Of course none of this will in any way diminish the vast volumes of hot air that will continue to be expended on why negotiations should be forced into existence immediately and everywhere. Nor will it diminish the micro-criticism of the people engaged in or not engaged in any particular set of negotiations. But hopefully this piece will make us all more informed spectators.
Saturday, July 19, 2014
Wednesday, July 2, 2014
Tech bubble 2.0
If you follow the stock market closely there has recently been talk about a new "tech bubble". In layman's terms this means that some analysts are floating the idea that the prices of tech stocks are overvalued (too high) and that we are about due for a correction (sharp drop in prices). This is entirely normal. Conventional wisdom says that if the market goes in the same direction for three to five years it becomes time for the trend to switch direction. Since stocks have been going up since the market bottomed in early 2009 it is time for them to start going down. Interestingly, there doesn't seem to be much talk of the general market correcting, just tech stocks. And at this point it is just a few voices. So what's with this "bubble" thing?
In 1841 (over a hundred and fifty years ago for those who are keeping track) Charles Mackay wrote a book called "Extraordinary Popular Delusions and the Madness of Crowds". The book is so influential you can buy it new from Amazon to this day. In that book Mackay popularized the term bubble to describe situations where large numbers of people pay extraordinary prices for things. The most famous (and to the modern sensibility ridiculous) example from this book is Tulip bulbs. But the events Mackey relates actually happened. The "bubble" of prices inflated and inflated and inflated. And it ultimately popped just like a soap bubble.
Mackay examines a number of other bubbles (and several other delusions not related to investment or finance). It is an interesting book and I recommend it. And investment mavens have been reading it and recommending it to other investment mavens for as long as the book has been in print. And, of course, bubbles have come into existence and popped many times since Mackay's book came out. That's why each generation of savvy investors keeps reading the book and keeps trying to be on the lookout for bubbles so they won't get caught when they pop. They, and I include myself in this particular "they", have had limited success. Why? It's hard, man. Let's look at "tech bubble 1.0" to see what I mean.
The modern era where the stock market pretty much seems to go up, except for the odd correction lasting at most a few months, is abnormal. Let me contrast it with another abnormal period where pretty much the opposite happened. On February 9, 1966 the Dow closed at 995.15. The economy looked good so people expected the Dow to "break 1000" for the first time in history within a day or so. It didn't. Instead that turned out to be the high for the year. The Dow see-sawed around and eventually broke 1000, and 1100, and 1200, and 1300. But each of those milestones were accompanied by lots of ups and downs and took many years. Then the Dow started to go down. Eventually the Dow bottomed at 776.92 on August 12, 1982. Over a 15 year period the Dow had dropped over 20%. By this time there was a lot of pessimism to mirror the optimism that had surrounded the 1966 high.
We now know the Dow turned the next day. And it proceeded to shoot up. Wall Street was very happy. But as the market kept going up they started worrying. And guess what? On October 19, 1987, roughly five years later, the market crashed. The crash was big enough and scary enough that the day was nicknamed "Black Monday". But the market quickly turned back up only to crash, but less spectacularly exactly a year later. And again it recovered quickly, climbed past its old all time highs and just kept going. For the most part it is still going today.
At about the time of the 1982 bottom a bunch of brokerage firms got together and decided it was time to modernize. The New York Stock Exchange had a trading floor, literally a room where people stood around yelling at each other and filling out pieces of paper. You had to literally be on the floor to buy or sell a stock. They decided that these new fangled things called computers could replace the trading floor. Then people could buy and sell stocks from anywhere. This exchange started going by the acronym NASDAQ (National Association of Security Dealers Automated Quoting system).
The PC was introduced at about the same time and quickly became popular. And people quickly started forming corporations to cash in on the popularity of PCs. Back then these were small companies so they ended up on the NASDAQ. In those days the Dow was made up of big companies that listed on the NYSE so the Dow was a proxy for how NYSE stocks were doing. Stock indexes are a good marketing took so the NASDAQ put together one of their own. And the NASDAQ Index was made up of stocks that traded on the NASDAQ exchange. So it had a lot of those small computer companies in it. And those small computer companies did very well. They did well in business but their stock prices did even better. So the NASDAQ Index shot up. On March 10, 2000 it closed at 5048.62. That turned out to be the all time high.
Bubbles are usually caused by or aggravated by insiders. The economic crash of 2008 is a classic example. The key players were all Wall Street types or were aided and abetted by Wall Street types. Another classic book is "Reminiscences of a Stock Operator" by Edwin Lefevre. This book is nominally fiction but it lays out real schemes used by operators to manipulate the prices of stocks and other commodities. You had to be an insider or be allowed to work through insiders to be able to pull off the schemes described in the book. "Reminiscences" was published in 1923, years before the crash of '29. But this book is another example of how old this type of behavior is. The technical details of the schemes change but the basic principals don't.
Anyhow, the stock prices of a wide range of tech companies spiraled up and up and up. Normally a close examination of the market would reveal the fingerprints of various operators in or closely associated with Wall Street. But not this time. What was going on was very simple. Small investors loved these computer related tech stocks. So they bought them. Wall Street's initial reaction was "yippee - more suckers to fleece". So they would get into these stocks with the intention of riding them up to the top then dumping them before the suckers caught on. But a funny thing happened. These stocks did not seem to have a top. They kept going up and up and up. Smart money on Wall Street kept missing out on further price increases.
This behavior feeds on itself (see "Extraordinary"). People see other people making tons of money by riding these tech stocks. In the early days some of these stocks (Apple, Microsoft, others) were a "good" investment. They showed an ability to make money then make more money. But a lot of these stocks didn't seem to have any kind of plan for eventually turning a profit. And their stocks went up right alongside the "good" tech stocks. Wall Street was completely flummoxed. They eventually figured you that you bought tech stocks no matter how bad their business plan was because if you closed your eyes and just bought you made tons of money.
So the market went up and up and up. By the late '90s it was primarily powered by these NASDAQ tech stocks. During this period the NASDAQ Index rose much more than the Dow did. The Wall Street smart money was completely confused. And I was right there with the Wall Street people. And that's the thing. You could find stories coming out by the bushel basket all through the late '90s. They all said the same thing: "tech stocks are in a bubble. The bubble is going to burst any day now". The problem is that if you followed this eminently sensible advice you lost out on the opportunity to make a lot of money. So everyone got swept along, even the smart money. The problem was that everybody knew the bubble was eventually going to burst. But every smart prediction of when this would happen turned out to be wrong. The bubble just kept growing and growing. All you could do was fasten your seatbelt and hang on.
Eventually the bubble burst in 2000, about 5 years after most people (me, most of Wall Street) thought it should. All the major Indexes, not just the NASDAQ, dropped sharply. And all of them except the NASDAQ eventually recovered. The Dow surpassed its all time record from this period years ago. The S&P 500 (considered the best of the major indexes by most professionals) also recovered and moved on to record territory years ago. But not the NASDAQ. Currently it is more than 500 points off it's 2000 all time record. This is in spite of the fact that its pattern of ups and downs has been broadly similar to the Dow and S&P once it bottomed after the 2000 crash. It went so high then that it has not been able to get back there since.
And that brings me back to the current situation with tech stocks. A lot of them went under after the 2000 crash. The remaining ones recovered generally along the lines of the broader market. They crashed in 2008 and have since recovered, again generally along the lines of the broader market. But they have been doing rather well in the last few years. The 3-5 year cycle says they are about due for a correction. So will they? I think not but I could be wrong.
Let me spend a little time comparing the current situation with the one in 2000. In 2000 there were lots of tech companies that lacked the usual fundamentals companies are traditionally rated on. Wall Street likes growth and these companies were growing at spectacular rates when measured by their customer base. But in a lot of cases these customers were not generating revenue. And, as a result, profits were nonexistent. In fact many of these companies were running up big losses. This was not necessarily a bad thing. The old saw goes "you have to spend money to make money". Often it is necessary to make a big up front investment in order to generate big profits later. Railroads must spend a lot of money laying track in order to later make a profit on passengers and freight. But these companies were spending a lot of money creating large customer bases but they had no idea how to "monetize" their customer base (get money out of them).
These companies said "we'll figure that part out later" but many of them never did. They ended up being washed away in the crash of 2000. What was left behind were the companies that had revenue streams and, in many cases, actual profits. And new companies came along. An example of a new company was Amazon. The business model for Amazon was "sell stuff". They started with books but quickly branched into other areas. Wall Street could understand the Amazon business model. In the specific case of Amazon, Wall Street has always been unhappy. Wall Street wants Amazon to have a higher profit margin but a lot of the general public is ok with Amazon's thin margins and resulting small profits. And Amazon has been able to maintain a high growth rate so Amazon's stock has done well.
But Amazon turns out to be atypical of the new generation of tech companies. Companies like Twitter and Facebook have gone with a different business model: advertising. Most of the post 2000 tech companies have gone down this road. Attract a lot of eyeballs and then put ads in front of those eyeballs. There has been a little of the previous cycle's "trust me" going on. But it has been "trust me - we will figure out how to pull in lots of ad revenue". Investors trusted the companies and they have generally delivered on the promise of lots of ad revenue.
But that brings me to the bubble I am actually concerned about and that's the ad revenue bubble. The trend of increasing ad revenue actually goes back a hundred years or so. Back in the day the ways you spent money on advertising were billboards and other signage, newspapers, and magazines. Then radio came along in the '30s. The "soap opera" type of show was actually created to sell soap products on the radio. The radio advertising model transitioned to TV in the '50s. Initially there were the "big three" TV networks, who reached into the home through local affiliates. Then cable came along and we had all those "cable only" channels. There are now hundreds of them.
Advertising agencies were not a big deal until radio came along. Before then the dealt mostly with magazine advertisements. But radio opened up new markets and gave advertisers the opportunity to spend a lot more money. Then TV came along and even more money could be spent. Production costs for radio ads were modest. Lots of money could be spent to make a TV spot. Then lots more money could be spent buying ad time on the Superbowl. The need for more and more elaborate ads got even greater with the advent of hundreds of cable channels. An ad really had to stand out or nobody would notice it.
In the beginning a billboard or sign could last years. Newspaper ads could be pretty basic and thus pretty inexpensive to put together. With radio production costs started to spiral. And TV and later cable just accelerated the spiral of production and distribution costs. The percentage of their overall budgets that the typical company dedicates to advertising and marketing keeps going up and up. And now, of course, we have the Internet. For the most part the old channels haven't gone away. There are still billboards and other signage, still radio channels, still TV channels, still cable channels. As a new channel opens up the percentage of advertising and marketing dollars devoted to the old channels goes down but in most cases that absolute amount doesn't. Mostly what we see is new dollars going into the new channel. And that is true with the Internet. Some of the money comes from cutting back elsewhere but a lot of it is new money.
And there is a fundamental truth about advertising. The point where on balance new advertising was generating new sales was reached decades ago. We are all subjected to ads for more goods and services than we can possibly purchase. This has been true for decades. And we have gone from ten times oversaturation to a hundred times to a thousand times or more. At best an advertisement diverts us from purchasing one thing in order to purchase something different. Or an ad causes us to keep purchasing something rather than switching to purchasing something else.
What has been going on for decades now is an ad war. On one side we keep putting up better defenses to advertisements while on the other side advertisers keep coming up with techniques for breaching those defenses. There is a novelty factor. I remember when they started running ads along with the trailers (actually just ads for other movies) that run before the movie starts in a movie theater. I am sure that when this started those early ads were effective. They were coming at us from a new direction. The same is true for the early internet ads. We had not yet built up our defenses against ads coming from this direction. But it doesn't take long. Then marketers have to come up with even more intrusive methods for getting in our face.
It was recently disclosed that Facebook did an extensive study (without telling any of the victims) of just what the tolerance levels of Facebook users were. I use a number of news web sites. They have all slowed down? Why? Because various delays are now built in while the extensive ad content loads. The page you want to view does not come up until all the add content is in place. Another trick they now use is to run a video (with an ad on the front) automatically whether you want to see the video or not. I tried switching to other news sites. But they all deal with the same ad agencies who all force them to use the same intrusive ad infrastructure. The latest advertising frontier is smartphones. But all the rules that work for web sites work equally well for smartphone screens. It is simply a matter of tweaking the technology to be smartphone compatible. I believe that particular technology problem has already been solved. Amazon has just released a "fire" smartphone that has been optimized to meet Amazon marketing needs.
In summary, the current business model for tech companies is to generate sufficient ad revenues to meet profit targets. This depends on there being enough ad revenues to support whatever new company is coming down the pike. But the market for ads has been massively oversaturated for decades. Companies must dedicate more money to advertising and marketing in spite of the fact that the effectiveness of these expenditures keeps diminishing. We are all bombarded with vastly more advertising than we can use. We are in a situation similar to the cold war when the question was "is nuking Moscow ten times over enough or should we plan on nuking it fifteen times over". Once the first bomb has gone off the marginal value of subsequent explosions is pretty much nil.
As in the case with tech companies in the '90s where the bubble went on far longer than it should have, the ad bubble has already gone on far longer than it should have. And we have already established that I am a lousy predictor in these situations. So I can't predict when the ad bubble will burst. My guess is that the advertising bubble will keep inflating for a while longer. So I will restrict myself to the prediction that the cause of the bursting of the current tech bubble will be the bursting of the ad bubble and leave it at that.
In 1841 (over a hundred and fifty years ago for those who are keeping track) Charles Mackay wrote a book called "Extraordinary Popular Delusions and the Madness of Crowds". The book is so influential you can buy it new from Amazon to this day. In that book Mackay popularized the term bubble to describe situations where large numbers of people pay extraordinary prices for things. The most famous (and to the modern sensibility ridiculous) example from this book is Tulip bulbs. But the events Mackey relates actually happened. The "bubble" of prices inflated and inflated and inflated. And it ultimately popped just like a soap bubble.
Mackay examines a number of other bubbles (and several other delusions not related to investment or finance). It is an interesting book and I recommend it. And investment mavens have been reading it and recommending it to other investment mavens for as long as the book has been in print. And, of course, bubbles have come into existence and popped many times since Mackay's book came out. That's why each generation of savvy investors keeps reading the book and keeps trying to be on the lookout for bubbles so they won't get caught when they pop. They, and I include myself in this particular "they", have had limited success. Why? It's hard, man. Let's look at "tech bubble 1.0" to see what I mean.
The modern era where the stock market pretty much seems to go up, except for the odd correction lasting at most a few months, is abnormal. Let me contrast it with another abnormal period where pretty much the opposite happened. On February 9, 1966 the Dow closed at 995.15. The economy looked good so people expected the Dow to "break 1000" for the first time in history within a day or so. It didn't. Instead that turned out to be the high for the year. The Dow see-sawed around and eventually broke 1000, and 1100, and 1200, and 1300. But each of those milestones were accompanied by lots of ups and downs and took many years. Then the Dow started to go down. Eventually the Dow bottomed at 776.92 on August 12, 1982. Over a 15 year period the Dow had dropped over 20%. By this time there was a lot of pessimism to mirror the optimism that had surrounded the 1966 high.
We now know the Dow turned the next day. And it proceeded to shoot up. Wall Street was very happy. But as the market kept going up they started worrying. And guess what? On October 19, 1987, roughly five years later, the market crashed. The crash was big enough and scary enough that the day was nicknamed "Black Monday". But the market quickly turned back up only to crash, but less spectacularly exactly a year later. And again it recovered quickly, climbed past its old all time highs and just kept going. For the most part it is still going today.
At about the time of the 1982 bottom a bunch of brokerage firms got together and decided it was time to modernize. The New York Stock Exchange had a trading floor, literally a room where people stood around yelling at each other and filling out pieces of paper. You had to literally be on the floor to buy or sell a stock. They decided that these new fangled things called computers could replace the trading floor. Then people could buy and sell stocks from anywhere. This exchange started going by the acronym NASDAQ (National Association of Security Dealers Automated Quoting system).
The PC was introduced at about the same time and quickly became popular. And people quickly started forming corporations to cash in on the popularity of PCs. Back then these were small companies so they ended up on the NASDAQ. In those days the Dow was made up of big companies that listed on the NYSE so the Dow was a proxy for how NYSE stocks were doing. Stock indexes are a good marketing took so the NASDAQ put together one of their own. And the NASDAQ Index was made up of stocks that traded on the NASDAQ exchange. So it had a lot of those small computer companies in it. And those small computer companies did very well. They did well in business but their stock prices did even better. So the NASDAQ Index shot up. On March 10, 2000 it closed at 5048.62. That turned out to be the all time high.
Bubbles are usually caused by or aggravated by insiders. The economic crash of 2008 is a classic example. The key players were all Wall Street types or were aided and abetted by Wall Street types. Another classic book is "Reminiscences of a Stock Operator" by Edwin Lefevre. This book is nominally fiction but it lays out real schemes used by operators to manipulate the prices of stocks and other commodities. You had to be an insider or be allowed to work through insiders to be able to pull off the schemes described in the book. "Reminiscences" was published in 1923, years before the crash of '29. But this book is another example of how old this type of behavior is. The technical details of the schemes change but the basic principals don't.
Anyhow, the stock prices of a wide range of tech companies spiraled up and up and up. Normally a close examination of the market would reveal the fingerprints of various operators in or closely associated with Wall Street. But not this time. What was going on was very simple. Small investors loved these computer related tech stocks. So they bought them. Wall Street's initial reaction was "yippee - more suckers to fleece". So they would get into these stocks with the intention of riding them up to the top then dumping them before the suckers caught on. But a funny thing happened. These stocks did not seem to have a top. They kept going up and up and up. Smart money on Wall Street kept missing out on further price increases.
This behavior feeds on itself (see "Extraordinary"). People see other people making tons of money by riding these tech stocks. In the early days some of these stocks (Apple, Microsoft, others) were a "good" investment. They showed an ability to make money then make more money. But a lot of these stocks didn't seem to have any kind of plan for eventually turning a profit. And their stocks went up right alongside the "good" tech stocks. Wall Street was completely flummoxed. They eventually figured you that you bought tech stocks no matter how bad their business plan was because if you closed your eyes and just bought you made tons of money.
So the market went up and up and up. By the late '90s it was primarily powered by these NASDAQ tech stocks. During this period the NASDAQ Index rose much more than the Dow did. The Wall Street smart money was completely confused. And I was right there with the Wall Street people. And that's the thing. You could find stories coming out by the bushel basket all through the late '90s. They all said the same thing: "tech stocks are in a bubble. The bubble is going to burst any day now". The problem is that if you followed this eminently sensible advice you lost out on the opportunity to make a lot of money. So everyone got swept along, even the smart money. The problem was that everybody knew the bubble was eventually going to burst. But every smart prediction of when this would happen turned out to be wrong. The bubble just kept growing and growing. All you could do was fasten your seatbelt and hang on.
Eventually the bubble burst in 2000, about 5 years after most people (me, most of Wall Street) thought it should. All the major Indexes, not just the NASDAQ, dropped sharply. And all of them except the NASDAQ eventually recovered. The Dow surpassed its all time record from this period years ago. The S&P 500 (considered the best of the major indexes by most professionals) also recovered and moved on to record territory years ago. But not the NASDAQ. Currently it is more than 500 points off it's 2000 all time record. This is in spite of the fact that its pattern of ups and downs has been broadly similar to the Dow and S&P once it bottomed after the 2000 crash. It went so high then that it has not been able to get back there since.
And that brings me back to the current situation with tech stocks. A lot of them went under after the 2000 crash. The remaining ones recovered generally along the lines of the broader market. They crashed in 2008 and have since recovered, again generally along the lines of the broader market. But they have been doing rather well in the last few years. The 3-5 year cycle says they are about due for a correction. So will they? I think not but I could be wrong.
Let me spend a little time comparing the current situation with the one in 2000. In 2000 there were lots of tech companies that lacked the usual fundamentals companies are traditionally rated on. Wall Street likes growth and these companies were growing at spectacular rates when measured by their customer base. But in a lot of cases these customers were not generating revenue. And, as a result, profits were nonexistent. In fact many of these companies were running up big losses. This was not necessarily a bad thing. The old saw goes "you have to spend money to make money". Often it is necessary to make a big up front investment in order to generate big profits later. Railroads must spend a lot of money laying track in order to later make a profit on passengers and freight. But these companies were spending a lot of money creating large customer bases but they had no idea how to "monetize" their customer base (get money out of them).
These companies said "we'll figure that part out later" but many of them never did. They ended up being washed away in the crash of 2000. What was left behind were the companies that had revenue streams and, in many cases, actual profits. And new companies came along. An example of a new company was Amazon. The business model for Amazon was "sell stuff". They started with books but quickly branched into other areas. Wall Street could understand the Amazon business model. In the specific case of Amazon, Wall Street has always been unhappy. Wall Street wants Amazon to have a higher profit margin but a lot of the general public is ok with Amazon's thin margins and resulting small profits. And Amazon has been able to maintain a high growth rate so Amazon's stock has done well.
But Amazon turns out to be atypical of the new generation of tech companies. Companies like Twitter and Facebook have gone with a different business model: advertising. Most of the post 2000 tech companies have gone down this road. Attract a lot of eyeballs and then put ads in front of those eyeballs. There has been a little of the previous cycle's "trust me" going on. But it has been "trust me - we will figure out how to pull in lots of ad revenue". Investors trusted the companies and they have generally delivered on the promise of lots of ad revenue.
But that brings me to the bubble I am actually concerned about and that's the ad revenue bubble. The trend of increasing ad revenue actually goes back a hundred years or so. Back in the day the ways you spent money on advertising were billboards and other signage, newspapers, and magazines. Then radio came along in the '30s. The "soap opera" type of show was actually created to sell soap products on the radio. The radio advertising model transitioned to TV in the '50s. Initially there were the "big three" TV networks, who reached into the home through local affiliates. Then cable came along and we had all those "cable only" channels. There are now hundreds of them.
Advertising agencies were not a big deal until radio came along. Before then the dealt mostly with magazine advertisements. But radio opened up new markets and gave advertisers the opportunity to spend a lot more money. Then TV came along and even more money could be spent. Production costs for radio ads were modest. Lots of money could be spent to make a TV spot. Then lots more money could be spent buying ad time on the Superbowl. The need for more and more elaborate ads got even greater with the advent of hundreds of cable channels. An ad really had to stand out or nobody would notice it.
In the beginning a billboard or sign could last years. Newspaper ads could be pretty basic and thus pretty inexpensive to put together. With radio production costs started to spiral. And TV and later cable just accelerated the spiral of production and distribution costs. The percentage of their overall budgets that the typical company dedicates to advertising and marketing keeps going up and up. And now, of course, we have the Internet. For the most part the old channels haven't gone away. There are still billboards and other signage, still radio channels, still TV channels, still cable channels. As a new channel opens up the percentage of advertising and marketing dollars devoted to the old channels goes down but in most cases that absolute amount doesn't. Mostly what we see is new dollars going into the new channel. And that is true with the Internet. Some of the money comes from cutting back elsewhere but a lot of it is new money.
And there is a fundamental truth about advertising. The point where on balance new advertising was generating new sales was reached decades ago. We are all subjected to ads for more goods and services than we can possibly purchase. This has been true for decades. And we have gone from ten times oversaturation to a hundred times to a thousand times or more. At best an advertisement diverts us from purchasing one thing in order to purchase something different. Or an ad causes us to keep purchasing something rather than switching to purchasing something else.
What has been going on for decades now is an ad war. On one side we keep putting up better defenses to advertisements while on the other side advertisers keep coming up with techniques for breaching those defenses. There is a novelty factor. I remember when they started running ads along with the trailers (actually just ads for other movies) that run before the movie starts in a movie theater. I am sure that when this started those early ads were effective. They were coming at us from a new direction. The same is true for the early internet ads. We had not yet built up our defenses against ads coming from this direction. But it doesn't take long. Then marketers have to come up with even more intrusive methods for getting in our face.
It was recently disclosed that Facebook did an extensive study (without telling any of the victims) of just what the tolerance levels of Facebook users were. I use a number of news web sites. They have all slowed down? Why? Because various delays are now built in while the extensive ad content loads. The page you want to view does not come up until all the add content is in place. Another trick they now use is to run a video (with an ad on the front) automatically whether you want to see the video or not. I tried switching to other news sites. But they all deal with the same ad agencies who all force them to use the same intrusive ad infrastructure. The latest advertising frontier is smartphones. But all the rules that work for web sites work equally well for smartphone screens. It is simply a matter of tweaking the technology to be smartphone compatible. I believe that particular technology problem has already been solved. Amazon has just released a "fire" smartphone that has been optimized to meet Amazon marketing needs.
In summary, the current business model for tech companies is to generate sufficient ad revenues to meet profit targets. This depends on there being enough ad revenues to support whatever new company is coming down the pike. But the market for ads has been massively oversaturated for decades. Companies must dedicate more money to advertising and marketing in spite of the fact that the effectiveness of these expenditures keeps diminishing. We are all bombarded with vastly more advertising than we can use. We are in a situation similar to the cold war when the question was "is nuking Moscow ten times over enough or should we plan on nuking it fifteen times over". Once the first bomb has gone off the marginal value of subsequent explosions is pretty much nil.
As in the case with tech companies in the '90s where the bubble went on far longer than it should have, the ad bubble has already gone on far longer than it should have. And we have already established that I am a lousy predictor in these situations. So I can't predict when the ad bubble will burst. My guess is that the advertising bubble will keep inflating for a while longer. So I will restrict myself to the prediction that the cause of the bursting of the current tech bubble will be the bursting of the ad bubble and leave it at that.
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