There Is No Tech Bubble. Still, Be Worried.
Andreessen Horowitz, the most innovative and outspoken of Silicon Valley’s big venture capital firms, recently came out with a presentation intended to kill the idea that there’s a new tech bubble under way. The 53-slide presentation, by Morgan Bender, Benedict Evans and Scott Kupor, takes on the idea that too much money is flowing into private technology companies, especially in the highly valued startups called “unicorns.”
First, a little background. Bubbles, by definition, pop, and if tech crashed it would hurt a lot of investors. People making the case for a bubble often focus on unicorn startups (those with a valuation of greater than $1 billion) such as Uber, which is now valued at $40 billion without having gone public. They claim that large private financing by late-stage venture capital, backed up by large asset managers like Fidelity or Tiger Global Management, have replaced initial public offerings as the driver of overvaluation. This is known as the “private IPO.” The pro-bubble case is that these private financing rounds have inflated the value of the unicorns without spilling over into the public markets.
Andreessen Horowitz’s team attacks this idea from a number of directions. First, they show that overall funding for tech startups -- both private financing and IPOs -- is still nowhere near the dizzying heights it reached in 1999 and 2000, especially when measured as a share of the economy. The same is true of venture capital fundraising. They also present various arguments that long-term earning potential for tech startups is much stronger this time around. (Bloomberg LP, the parent company of Bloomberg News, is an investor in Andreessen Horowitz.)
The Andreessen Horowitz presentation makes a very convincing case. We should not be drawing a parallel between the boom in private late-stage funding of unicorn startups and the late-’90s IPO boom. They just don’t look like the same phenomenon.
So there’s probably not a unicorn bubble. How about a tech bubble more generally? The Andreessen Horowitz team points out that the tech sector isn't taking over the Standard & Poor's 500 stock index the way it did in the late-’90s tech bubble: The share of tech in the index has been flat for about 12 years now. And, as Sam Altman pointed out on Twitter, stock valuations for technology companies don’t look any higher than other stock valuations; the price-to-earnings ratio of the tech component of the S&P is in fact lower than for the index as a whole. So we’re probably not in a tech bubble of any kind.
That said, there was one Andreessen Horowitz slide that's ominous. It shows that all the unicorns together are valued at slightly less than Facebook. That reminded me of an e-mail debate between financial economists Eugene Fama and Ivo Welch, on the question of whether the ’90s tech bubble was really an episode of market irrationality. In that debate, Fama said the following:
During 1999-2000 there [were] 803 IPOs with an average market cap of $1.46 billion … 576 of the IPOs are tech and internet-related … [thus] their total market cap [was] about $840 billion, or about twice Microsoft's valuation at that time. Given expectations at that time about high tech and the business revolution to be generated by the internet, is it unreasonable that the equivalent of two Microsofts would eventually emerge from the tech and internet-related IPOs?
In other words, Fama is saying that the tech bubble of 1999-2000 was caused by rational investor expectations, not by irrational exuberance. (Obviously, that view isn’t universally held.)
Fama’s quote highlights two very important things about bubbles. First, even in the most dramatic cases, it’s not easy to know you’re in one. Second, true bubbles often involve overvaluation throughout the entire market, not just in one segment. Fama is absolutely right about all those IPOs being worth only two Microsofts.
But Microsoft’s price in 1999-2000 was about 70 times its earnings. After the 2000 crash, that plummeted to about 30, briefly recovered, then drifted down again. Even if Fama is right that tech investors in 1999-2000 expected the tech IPO market to produce two new Microsofts, he glosses over the fact that in hindsight, investors were drastically overvaluing Microsoft.
So what’s Facebook’s price-to-earnings ratio right now? Over 80.
The danger isn’t that we’re in a unicorn bubble. The danger isn’t even that we’re in a tech bubble. The danger is that we’re in an Everything Bubble -- that valuations across the board are simply too high. The Shiller CAPE ratio, generally regarded as a good measure of the market’s over- or undervaluation, is indeed unusually high -- though not nearly as high as in January 2000.
So what happens when China’s housing and stock bubbles finally crash, as both are probably in the process of doing? What happens when the Federal Reserve raises interest rates? It’s possible that not much will happen. Or it’s possible that there will be a big crash that it will take markets a few years to recover from. If it’s the latter, then unicorn startups will see their funding dry up along with everyone else.
In other words, the tech sector doesn’t seem to be creating a bubble like in the late ’90s, but valuations are looking slightly worrying at the overall market level.
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