A Tech Bubble or Just a Mistake?
There has been quite a lot of talk about a new tech bubble for the past few years. My Bloomberg View colleague Katie Benner earlier this week took a critical look at claims of overvaluation in the biotechnology sector. Billionaire Mark Cuban last week issued a warning about excessive valuations for start-up companies, and some venture capitalists agree. Hedge-fund mogul David Einhorn also has made a case for a tech bubble.
It may very well be the case that tech stocks and venture companies are overvalued. I don’t know and probably most other people don't know either. But today’s tech bubble isn't likely to be the same kind of bubble we saw in the late 1990s -- if it's even a bubble at all.
First let's distinguish between a bubble and what really should be called a pricing error. There is a difference.
A pricing error is when some people think some asset is worth a lot, and they turn out to be wrong. Oops. That’s just another day in the financial markets.
Economists think that a bubble is a lot more than that. They see a bubble as a game of the “greater fool,” where everyone buys at prices they know are inflated because they think they can find someone else to sell to at an even more inflated price. This is called a speculative bubble. For an interesting model of the 1990s tech bubble, see this paper.
But speculative bubbles only work if people think there’s a greater fool out there somewhere. Today's tech start-up investment frenzy has a very defined chain of resale. First the angels and the crowd funders put in some money. Then there’s a chain of venture capitalists, who may or may not sell to the next VC in the chain. Eventually, though, if the venture doesn’t die, all the early-stage funders sell when the venture either offer shares to the public or gets acquired.
Now, initial public offerings are a lot rarer than they used to be. They’re also a lot bigger -- Facebook’s 2012 IPO raised about 300 times the amount of money Amazon’s did 15 years earlier, and the company went public at a much larger valuation. The trend toward bigger, later IPOs has been blamed on regulation (especially Sarbanes-Oxley Section 404), on the proliferation of short-sellers who can kill a small public company with negative rumors, and on disillusionment after the crash of 2000. But whatever the cause, it means that most of today’s venture companies won't provide their investors with an exit by going public -- instead, they will be acquired by large companies such as Google, Facebook, Amazon, Apple and Microsoft.
So unlike in the 1990s, early-stage investors now know exactly who the most likely end-stage buyers are. That means that if early-stage investors plan on selling to a “greater fool,” it must be because they think Facebook, Google and the rest are the fools.
It’s possible that Facebook, Google and company really have consistently overvalued the tech companies they have been acquiring. But if that’s true, then what we’re dealing with isn’t a speculative bubble -- it’s just a normal, everyday case of investors making a mistake about valuations.
The next question is: Are the big companies making a big mistake? I’m no expert on tech stock valuations, but there seems to be a pretty obvious reason for big tech companies to be paying top dollar for little tech companies: insurance.
Think about it. Microsoft ruled the PC market, but when lots of computing started moving online, it lost out to Google. Google is the king of search, but it failed to compete with Facebook in social networking. And already, young people are starting to abandon Facebook for things like Instagram and texting/chat apps. All of these companies have to be looking for the next platform with a strong network effect that will draw the eyeballs of the fickle, tech-addicted youth. In that kind of climate of extreme uncertainty, it might make sense for a company to spend big on acquisitions, in the hopes of snagging the next big thing -- or at least preventing it from growing big enough to eat its customer base.
So what happens if funding dries up for venture firms? A lot of angels will lose money, but angels tend to be rich people who can afford to take the loss. VC funds will lose money, but VC is still a fairly small piece of the U.S. financial markets. Crowdfunded equity is only about $10 billion. By comparison, the dot-com bubble that ended in early 2000 cost investors -- many of them middle-class individuals -- as much as $6 trillion.
What about the Nasdaq, which is at all-time highs? In terms of price-to-earnings ratios, the index certainly looks no more overvalued than the U.S. stock market as a whole. Make of that what you will.
In any case, the bottom line is this: Sure, there’s a possibility that the tech-stock market will turn down. In fact, wait long enough and at some point it almost certainly will. But the current situation looks very little like the dot-com bubble of the late '90s.
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