The prices of shares in US technology companies have skyrocketed in recent months. A number of indicators suggest that these firms are overvalued, perhaps the strongest sign of a ‘tech bubble’ being the extent to which insiders are selling their shares.
Shares in new technology companies in the United States have enjoyed a remarkable 16 months: the New York Stock Exchange Fang+ Index has risen over 100%. This index measures the performance of Facebook, Amazon, Apple, Netflix and Alphabet (formerly Google) or the FAANG companies as they are collectively known, as well as other large tech companies.
The SDPR Kensho Clean Power exchange-traded fund (ETF), which invests in renewable energy companies, has witnessed similar returns over the same period. But these are dwarfed by the return on shares in electric car company Tesla, which have risen by over 700% since the start of 2020 (see Figure 1).
This might not seem surprising given how much life has moved online since March 2020 – a shift reflected in the record profits that some tech companies have reported. But the run-up in the prices of tech shares appears to be mainly an American phenomenon: the performance of European equivalents of the Fang+ index, such as the FTSE techMark All-Share index and the SDPR MSCI Europe Tech ETF, which invests in European tech shares, have been much less spectacular.
Nevertheless, the high returns seen in the United States have led several commentators to suggest that we are now in a technology bubble.
Figure 1: Return on shares in new technology companies since the start of 2020
Source: Google Finance
Note: Returns are measured from 3 January 2020 to 7 May 2021
What is a tech bubble?
A technology bubble is a substantial rise and fall in the prices of assets associated with a new technology (Kindleberger, 1996; Quinn and Turner, 2020). They are generally thought to arise as a result of excitement surrounding a new technology, sometimes accompanied by high initial profits, which attract capital to firms that use this technology. An initial increase in prices then draws speculative or ‘momentum’ traders, causing prices to continue to rise, often to levels that are difficulty to justify based on the profitability of the underlying firm (Perez, 2010).
While valuations may appear to be excessively high to professional investors, they often persist for several reasons. First, because the technology is so new and its economic impact is highly uncertain, there is little concrete information with which to value new tech companies (Goldfarb and Kirsch, 2019).
Second, excitement surrounding technology can lead to high levels of media attention, drawing in more and more naïve investors. This is often accompanied by the emergence of a ‘new era’ narrative, which appears to justify the very high prices of tech companies’ shares (Perez, 2010; Shiller, 2015; Goldfarb and Kirsch, 2019).
The most famous and largest tech bubble in history was the dot-com bubble of the 1990s. The shares of new information technology and internet companies surged during the late 1990s, with companies like WebVan and Pets.com valued at hundreds of millions of dollars despite making heavy losses. In 2000, the bubble burst and many of these companies went bankrupt. The magnitude of the dot-com bubble can be seen in Figure 2.
Figure 2: The dot-com bubble
Source: Quinn and Turner, 2020
The 1920s stock market boom in the United States also had a large new technology component to it (Nicholas, 2008; Quinn and Turner, 2020). American society was transformed by electrification in the 1920s. This made mass production possible and all kinds of consumer goods cheaper to produce – from automobiles and telephones to washing machines and refrigerators.
A lesser-known tech bubble is the UK bicycle mania of the 1890s, when hundreds of bicycle companies were floated on UK stock exchanges and the price of bicycle shares rose substantially and then imploded (Quinn, 2019). In this instance, the underlying new technology was the pneumatic tyre and diamond frame, which transformed bicycles from a minority pursuit into a mass market means of transport.
Is there a tech bubble in the market today?
Bubbles, by definition, burst. As a result, it is impossible to say with absolute certainty whether one exists or not, and identifying bubbles requires the use of judgement.
Many investors look for qualitative indications that the market is in a bubble. For example, Quinn and Turner (2020) argue that bubbles occur when three necessary components are present: marketability; money/credit; and speculation.
Each of these is abundant in today’s markets. Marketability – the ease of buying and selling assets – has increased substantially in the past year with the proliferation of zero-commission trading apps and fractional trading. Near-zero interest rates and extraordinary central bank interventions have led to abundant money and credit. Speculation and momentum trading also appear to be rife, the most obvious example being the recent GameStop squeeze.
Another warning sign is the entry of large numbers of new and inexperienced investors into financial markets. This can be seen today from the enormous growth in the trading app Robinhood: the number of users has grown from 0.5 million in 2015 to 13 million last year. The structure of the app also encourages momentum trading.
Bubbles also tend to be accompanied by new era narratives that rationalise why old investing rules no longer apply (Shiller, 2015). Again, these appear to be present today in the belief that the pandemic will usher in a new economy dominated by technology firms.
Another way of assessing whether we are in a technology bubble is to try to determine whether the technology companies could become profitable enough to justify their current share price. The most common valuation metric is the price-to-earnings (P/E) ratio, which links a company’s share price to its earnings.
The S&P 500 currently has a P/E of 37, which is considered very high by historical standards. Tesla’s P/E is currently over 1,100, suggesting that it is spectacularly overvalued relative to its current profitability. But such metrics struggle to capture the true value of technology firms – especially as the business model is based around future growth, whereas P/E looks only at past earnings.
Perhaps the most convincing argument that technology shares are overvalued is the behaviour of insiders. Many tech firms are selling large numbers of their own shares: Blink Charging issued 5.4 million new shares in January, while Tesla issued over 50 million new shares in 2020.
Others have been extensively using their own shares instead of cash to pay their employees. The price of Palantir, a data analytics firm, has fallen by 42% from its February peak, partly due to the expiration of lock-up agreements on employee-held shares, which prevented insiders from selling their shares for a certain period. When the cryptocurrency trading platform Coinbase went public on 14 April, insiders sold $5 billion of shares on the opening day of trading. In other words, those closest to technology firms often seem to believe that their shares are overvalued.
Should policy-makers be concerned about tech bubbles?
Many historical bubbles have wreaked havoc on the economy and have been extremely destructive. For example, the housing bubble of the 2000s was the major contributor to the global financial crisis of 2007-09 (Quinn and Turner, 2020).
But most historical tech bubbles may have been socially useful, in that although they may not be efficient or optimal, they have bequeathed something valuable to society. The UK railway mania of the 1840s led to the development of a rail network, and the dot-com bubble to the development of a fibre optic cable network (Eatwell, 2004). Many firms that floated during the UK bicycle mania, such as Raleigh, Dunlop and Rover, went on to become household names many years after the bubble burst (Quinn and Turner, 2020).
Some commentators, such as William Janeway, an economist and successful venture capitalist during the dot-com bubble, go further and argue that several transformative technologies could not have been developed without the existence of bubbles (Janeway, 2018).
It has been suggested that central banks should attempt to prick bubbles by raising interest rates (Roubini, 2006). But given that the consequences of technology bubbles can be so ambiguous, this risks doing more harm than good (Posen, 2006). Monetary policy typically focuses on maintaining stable inflation and low unemployment, and these principles are rarely worth compromising for the sake of an overvalued asset class.
Instead, policy-makers should ensure that systemically important banks will not collapse when the bubble bursts. Financial institutions are typically much less vulnerable to stock market bubbles than they are to housing bubbles. But the enormous losses experienced by banks after the collapse of Archegos suggest that the banks themselves are not always entirely aware of the extent to which they are exposed to a crash. Greater oversight may be necessary.
Finally, regulators need to protect investors from the fraud that often accompanies bubbles (Kindleberger, 1996). It is common for innovative firms to oversell the potential of their technology: Tesla, for example, has repeatedly underestimated how long it will take for its cars to become fully autonomous.
At times, this can spill over into outright deceit, most famously in the cases of Theranos and OneCoin. Many cryptocurrency projects closely resemble Ponzi schemes, and the US Securities and Exchange Commission (SEC) has recently taken action against the founders of Ripple, one of the most widely traded coins, for offering unregistered securities.
Preventing fraud is important for economic reasons as well as moral ones. If investors can be misled without consequence, this can lead to problems of ‘asymmetric information’, whereby outsiders have no way of knowing which firms are fraudulent. As a result, they may end up investing less in technology firms in general – making it much more difficult for truly innovative firms to raise money.
Where can I find out more?
- A stock market bubble? It’s more like a fire: Jason Zweig of the Wall Street Journal explores the US tech bubble.
- Pandemic tech bubbles echo those of the dotcom era: Richard Waters of the Financial Times discusses the pandemic tech bubble.
- What’s good about tech bubbles: Shira Ovide of the New York Times discusses the usefulness of tech bubbles.
- A podcast on the bicycle mania: William Quinn chats about the UK bicycle mania of the 1890s and corners in cycle shares.
- Why has the stock market bounced back when the economy seems so bad? William Quinn and John Turner explore the possibility that there is a bubble in the stock market.