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Is a dotcom bubble repeat underway?

LiveMint logoLiveMint 23-07-2017 Livemint

This time is different.” Those are usually famous last words when it comes to markets. But it’s what a number of industry experts have been saying about the US tech sector for the past three years or so, while others warn of a tech bubble. Last week, the S&P 500 technology index went past its March 2000 peak. The latter, of course, was the dotcom bubble’s acme and dying gasp both. Is this a warning, or is it truly different this time?

The San Francisco region is well acquainted with the folly of greedy optimism. Halfway through 1847, the city had less than 500 inhabitants. The California Gold Rush took off in 1849. By the end of the year, San Francisco had between 25,000 and 30,000 inhabitants. Gold fever was in the air. Dubious businesses flourished at the merest hint of prospective gold strikes. The city’s real estate boom would have given the apparatchiks trying to control China’s real estate bubble nightmares. About a century-and-a-half later, history repeated itself.

The gag, made in hindsight, that all that was needed to get funding during the internet boom’s long summer in the late 1990s was to tack on a “.com” to the end of a business venture wasn’t far off the mark. It was the dawn of the consumer internet era. In such fledgling, immature sectors, there is a dearth of past experience to guide projections of business potential and ground speculation. The fear of missing out overrode the fear of making losses. This unmoored both publicly listed companies and the start-up space from reality.

Thus, by 2000, the reigning tech giants of the day had bizarre valuations. Microsoft traded at 59 times earnings, Cisco at 179 times, Oracle at 87 times and Intel at 126 times. On an average, S&P 500 technology groups traded at 73 times earnings at that point, according to Bloomberg data. These valuations had little to do with cash flows and revenue potential. It was the same story with tech start-ups. They were going public practically overnight as such things are measured—at a median age of five years—with reliable revenue streams strictly optional. Burn rates were scorchingly high, often because of optimistic internal spending and massive advertising campaigns rather than core growth-focused outlays.

The S&P 500 technology index today paints a very different picture. According to the Financial Times, tech stocks are trading at about 19.4 times 2017 full-year earnings, while the S&P 500 is at 19 times. The FAAMG behemoths—Facebook, Amazon, Apple, Microsoft, Google—are all within striking distance of those numbers. Interestingly, they are increasingly being seen as safe havens—low volatility stocks at a time when the unpredictability of Donald Trump’s presidency and the lack of clarity about his economic agenda and ability to execute it are causing unease. And unlike in 2000, tech index valuations as a whole are tracking earnings growth, which is accelerating.

That hasn’t stopped warnings about a bubble. For instance, Goldman Sachs released a report last month that warned about a “valuation air pocket” that is “creating cause for pause”. And granted, there are some speed bumps on the horizon such as European antitrust proceedings against the tech giants could lead to paradigm shifts in the way they do business, and the inherent unpredictability of a cutting-edge industry.

But the sector has also changed fundamentally in ways that preclude a dotcom bubble repeat at the present moment—as far as listed companies go, at least. The market has matured considerably in the 17 years since. Tech businesses were something of a novelty in 2000. They are integral to fundamental shifts in economic and business models now. Network effects are far more entrenched. The links with other sectors are far deeper. Amazon’s cloud services, for instance—its main source of operating profit—serve as the spine of every kind of business. These are fundamental changes that cannot be rolled back sector-wide even if individual tech companies flounder.

The start-up space, however, is a different matter. If there is a bubble to be found, it is here. When the term “unicorn” was coined in 2013, there were 39 of them. Today, according to the TechCrunch database, there are 261 of them with 90 more inching their way towards the mark. The gig economy is the new frontier, as unsettled and prone to speculation as the tech sector as a whole was in 2000.

Tech giants like FAAMG are acquiring start-ups for eye-watering sums, creating an additional incentive. Venture capital funding resembles an all can you can eat buffet. And there is plenty of funding to now be had even for the late stage sector from other sources like pension funds and sovereign wealth funds. This is creating a mirror image of the 2000 IPO problem. As the Uber saga has shown, the plentiful funding means extended runways, and consequently, a lack of the discipline and market focus that being a listed company can bring.

In The Annals of San Francisco, published in 1855, the authors—three journalists who had witnessed the gold rush—wrote, “And everybody made money, and was suddenly growing rich…”. That same lure of imminent riches spurred Silicon Valley in 2000. It is doing so again. The bubble is smaller and less potentially damaging than the dotcom episode—but it certainly exists.

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