Financial bubbles - great stories but bad investments

Financial markets have a habit of repeating themselves. Every so often, investors become excited about a new technology or industry sector. In response, prices will often rise rapidly, drawing in more buyers and pushing asset prices higher.

These price increases may sometimes be justified. Yet, there will be occasions when there is a dislocation between prices and reasonable fundamental expectations. When this occurs, it can mean that a financial bubble has formed. 

Financial bubbles have been present in financial markets for hundreds of years. The growth of railways during the Victorian era, the dot.com sector at the turn of this century, residential property in China’s main cities and cryptocurrencies all exhibited bubble-like behaviour.

The dot.com era is one of the clearest examples of what can happen. Investors rushed into technology stocks. This drove the Nasdaq index up more than sixfold before it suffered a dramatic collapse in March 2000. It took the index another 15 years to recover to its historic peak.

If bubbles follow a familiar pattern, why do they keep happening and why are so many investors caught up in them?  

Rinse, repeat  

US economist Hyman Minsky identified five stages in a financial bubble.

1.    Displacement
The new, new thing. This occurs when investors identify a new and exciting catalyst. This could be a technology, product or theme. Something such as very low interest rates could drive this stage.

2.    Boom
Momentum builds. High returns for those who invested early. Outperformance encourages new investors, while media coverage and anecdotal stories of high returns fuel more interest. Retail investors aren’t the only ones drawn in. Many professional investors such as pension funds and asset managers ride a rally because the fear of missing out (FOMO) will often be greater than the risks of a correction.

3.    Euphoria
This time it’s different. Asset values continue to rise, supported by new valuation indicators showing that prices are justified. New investors continue to be drawn in. Perhaps this time, it really will be different?

4.    Profit taking
The smart money heads for the exit, if it hasn’t already. Prices and share trading volumes may remain extended. Daily price moves may become more volatile. This stage is easier to identify with hindsight.

5.    Panic
Prices fall, often precipitously. Regulators will often tighten the rules, hoping this will minimise the chances of a repeat bubble and crash. Critics point out that this addresses issues associated with the bubble just popped…it won’t prevent future bubbles.

Are we in an AI bubble?

Frustratingly, financial bubbles are usually only obvious after they burst. Before that happens, differentiating between a transformative technology and unrealistic investor expectation can very often prove difficult.

While much of AI’s potential is still to be unlocked, it may be premature to categorise current market conditions as a broad-based bubble. A more accurate assessment might be that it represents an exceptional technological revolution, albeit one where there are bubble-like characteristics in some areas of the market.  

Those arguing that there is an AI bubble point to the rich valuations and annual capital expenditure commitments approaching $1trillion by the end of the decade. There is also and an increasingly complex web of interdependence between AI developers, cloud providers (hyper-scalers) and semiconductor manufacturers. 
Investing in many of these companies effectively means placing large bets on sales and profits that may be years away, if they are generated at all. Two of the largest AI providers, Anthropic (Claude) and OpenAI (ChatGPT) are not yet profitable, but are expected to launch their initial public offerings by next year.

The contrasting view is that AI has few comparisons with previous bubbles. Many leading technology companies such as Alphabet/Google, Meta/Facebook and Amazon are profitable, generate substantial cashflows and possess strong balance sheets. This is very different from the dot.com bubble, when many companies had limited sales and low levels of profitability and cash generation, if at all. Today’s AI adoption continues to spread rapidly across multiples sectors, with company managements increasing reporting tangible benefits.

Yet for investors, a technology’s ability to change the world is not necessarily the same as its ability to generate attractive investment returns. While the internet continues to transform all aspects of life, many investors would bought technology shares at the height of the late-1990s bull market suffered severe losses when expectations did not materialise.

Share prices do not reflect the quality or usefulness of a company’s products. Instead, they reflect expectations about its future earnings. With many companies to choose, investors will be making difficult assumptions on those likely to succeed. AI may prove every bit as transformative as its supporters believe. Yet a historic turning point in markets can still result in periods of exuberance, with share prices ahead of fundamentals.    

Are bubbles always a bad thing?    

Despite the wealth destruction when financial bubbles go pop, they can have long-term benefits. Many companies that collectively invested up to $500 billion on wireless infrastructure during the dot.com bubble went bust before they could use it. Bought cheaply, this infrastructure helps underpin much of today’s internet. Likewise, the Victorian-era railway boom and bust in the UK and US left a substantial rail infrastructure behind.

At the other extreme, little good came of the US housing bubble. This was caused by banks providing mortgages to high-risk customers. When they started defaulting on their loans, the effects spread and led to a global banking crisis and a slowdown in global economic growth.¹    

All bubbles start out as speculative, maybe as a story or an idea. Some are healthy, promoting innovation, stimulating capital investment and spending and in turn accelerating growth. Some, as highlighted above, leave nothing positive behind and are just a misallocation of resources.

Why do investors get caught up in bubbles?

Financial bubbles rarely feel obvious at the time, though they may be in hindsight. Rising prices attract more attention and this is supported by positive headlines, analyst upgrades and the chances of easy money. This creates a positive feedback loop but eventually expectations become unrealistic and prices fall. Instead of selling, many investors hold on, believing that any setback will be temporary.

Bubbles can keep growing because investors gamble that rising prices confirm the original investment thesis. The longer this trend continues, the easier it is to believe that “this time it really is different” and that traditional valuation measures no longer apply.

Differentiating bubbles from a bull market

It’s not clear cut. In a healthy bull market, prices rise because companies are generating more sales and cash. In a bubble, share prices will go beyond any reasonable measure of fundamental value. High flying companies in a bubble are often not generating earnings today, its all about the future.

During the dot.com bubble at the turn of the century, many companies had no earnings. This meant they couldn’t be valued on traditional metrics (itself a sign that parts of the market were flashing red). Instead, analysts created a range of non-standardised measures to support excessive valuations. This included ‘page views’ which was based on website traffic, and using a price-to-sales ratio, valuing a company based on multiples of its annual sales. Changing the name of companies to include the .com suffix would often provide a short-term boost to the share prices for these companies. 

Something similar happened during 2017-18’s cryptocurrency retail bull market, when beverage maker Long Island Iced Tea Corp changed its name to Long Blockchain Corp. in December 2017. Despite no exposure to cryptocurrencies, the company’s share price rose dramatically before correcting.

In a bubble, valuations start to rely on perfect outcomes. So, the assumption will be that a company with low sales and generating no cash but attracting multiple page views will be able to convert this into cash. In contrast, the on-going outperformance for US tech companies has been led by strong customer demand and high profitability, helping push their share prices and relative value higher.

When hype overtakes fundamentals

Financial bubbles are often described as market failures. Yet they are really failures of investor judgement. Bubbles are fuelled by a convincing story that whatever it is will be the next “new thing”. Combined with rapidly rising prices, it reinforces the belief that the old rules no longer apply.

Yet when the excitement fades and the momentum subsides, the outcome can be painful. Prices correct by falling and investors are once again reminded that fundamentals still matter, at least until the next time.

What bubbles teach us

The most practical lesson from bubbles is that identifying them when they are underway is much harder than it seems with hindsight. Higher asset prices are underpinned by a good story and real innovations. This makes it difficult to differentiate a bull market from speculation.

Trying to anticipate the next new thing, or when a bubble will burst is unlike to be successful. Nor does a transformative technological development necessarily make a great investment. By the time prices are detached from reality, the opportunity may already have passed. Yet being among the first investors to act doesn’t necessarily deliver the rewards.  Railways and the internet have transformed the world, but many of the benefits accrued to those who followed behind and bought the assets cheaply after these bubbles popped.

The AI story is still be written. A less risky approach for investors who wish to participate is to remain diversified and focus on longer-term investment goals.

Source

¹ Lasting Effects: The Global Economic Recovery 10 Years After the Crisis. IMF Blog.