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.
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