Wait a minute. I’ve seen this movie before.
In a December 1996 speech, US Federal Reserve chairman Alan Greenspan coined the phrase that has defined him since.
“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions …?”
In citing irrational exuberance, Greenspan was trying to talk down what became the Internet bubble. What was stunning in hindsight was how investors ignored his warning and paid ever-higher prices for tech stocks of questionable value for more than three years until March 10, 2000, when the Nasdaq peaked at 5,408.60 and the bubble finally burst.
Recently, concerned about some tech company growth metrics, Securities and Exchange Commission (SEC) c chairwoman Mary Jo White said, “Consider a company that correctly claims it has a hundred million users, and that the rate of user growth is expected to continue to grow at double-digit rates. That certainly sounds good, and it would seem to bode well for the prospects of the company. But what if only a fraction of those users are paying customers? What does that mean for future financial results?”
White might have been referring to Twitter, which recently completed an IPO on the New York Stock Exchange at a lofty price, even though it has yet to turn a profit.
White said SEC staff has been scrutinizing these “unique financial or operational metrics.”
So, are there any similarities in economic conditions and markets between these two eras that might have triggered cautionary comments from senior officials?
I’m glad you asked.
Generally speaking, investors had soured on real estate and financial services sectors, and there was falling interest in commodities during both of these periods.
Twenty years ago, the savings and loan crisis in the U.S. had wiped out investor confidence in both real estate and banking sectors. By 1995, 747 failed S&Ls (similar to Canadian credit unions), with a book value of $402 billion, had been shut down. The total estimated loss was $370 billion, including $341 billion taken from taxpayers. In addition to withering interest in commodities, it was a time of low inflation.
The current cycle is still heavily influenced by the financial crisis that began in early 2006 in the U.S. when the subprime mortgage market started defaulting. To finance a red-hot residential real estate market, the financial services industry had created and sold unregulated collateralized mortgage securities and had insured them with credit default swaps. By 2008, no one trusted these instruments any more, leading to a massive credit freeze and the collapse of the real estate and banking sectors. As before, with investors showing little interest in commodities after a long bull run, inflation is also low.
Low interest rates mean low yields. Unattractive fixed income investment opportunities coupled with a lack of confidence in real estate and commodities markets resulted – then and now – in a hunt for better investment returns elsewhere.
In both cases senior officials warned about investment in the technology sector, which I don’t think is a coincidence. The common message of Greenspan and White seems to be that while traditional financial analysis is used for determining valuations for other asset classes, financial metrics don’t work for tech companies that don’t have earnings or even revenue.
Tech companies often try to present other metrics to explain their value propositions, including exuberance, or hype, which can make their values suspect or at least speculative.
Given that the surge into technology investing is happening again, investors would be wise to be wary about rising technology company values based on other than reasonable valuation metrics.
