Welcome to the Capital Note, a newsletter about business, finance, and economics. On the menu today: the bubble puzzle, the lira tanks, and a hot take on tulipmania. To sign up for the Capital Note, follow this link.
Bull Market or Bubble?
Talk of stock-market bubbles has been a perennial feature of the post-financial-crisis world. A ten-year bull market, only briefly halted by the pandemic, has commentators and investors speculating about a sudden melt-up. Recent rallies in Bitcoin and “meme stocks” such as GameStop have brought worries of a speculative mania back into focus.
Famed investor Jeremy Grantham recently argued: “Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behavior, I believe this event will be recorded as one of the great bubbles of financial history, right along with the South Sea bubble, 1929, and 2000.”
A recent Goldman Sachs report, however, argues that the bubble narrative is reductive. I’ll highlight two points that are often overlooked in the debate over stock-market valuations. The first is that most stock rallies are not bubbles. Yale professor William N. Goetzmann finds that the probability of a “correction,” or 10 percent decline, following a doubling in market value is roughly 10 percent. In other words, 90 percent of rallies are real and sustainable. “Bubbles are booms that went bad. Not all booms are bad,” argues Goetzmann.
The next, and especially overlooked point, is that in “winner takes most” industries, such as software, valuations will be skewed to the upside. Consider the ride-share market, in which Uber and Lyft are the main competitors. Investors in Uber are betting that it will take over the ride-share industry and create value in adjacent markets, such as delivery, as well. Investors in Lyft are betting that their company will do the same.
In a world of low marginal costs and potentially unlimited reach, the upside available to companies like Uber is almost unlimited: It can leverage its user base and logistical infrastructure to enter any number of markets. This means that the aggregate value of ride-share stocks may exceed the ultimate value of the ride-share industry once a dominant player emerges. The Goldman Sachs report puts it this way:
Often an innovation attracts many start-up companies, any of which might turn out to dominate the industry, but with no knowledge of which is likely to succeed. As a result, many companies rise in valuation to reflect the possibility of being the eventual winner but with the result that the combined value of all competitors far exceeds the potential profits that the industry or market can reasonably sustain.
It’s also difficult to determine the addressable market of emerging companies. In 2014, NYU’s Aswath Damodaran pegged the size of the ride-share market at $12 billion, based on the existing market for cabs. Only five years later, Lyft and Uber collectively facilitated around $30 billion in rides. The two companies sufficiently improved the customer experience to triple the total size of the cab market. Those valuing tech start-ups have to price in the vague but real possibility of enormous value creation demonstrated by Uber and Lyft.
Then again, it’s unclear when or how either company will turn a profit. Each of the many start-ups going public now could be the next Amazon – or the next Pets.com.
Around the Web
The decision by President Erdogan at the weekend to dismiss Naci Agbal after just four months in the job during which he engineered a strong rebound in the lira is the latest in a long series of decisions that have worried investors in one of the world’s biggest emerging markets. Agbal was fired after delivering a bigger than expected raise in interest rates last Thursday — going against Erdogan’s longstanding and contested view that high interest rates cause inflation rather than curing it. He was replaced with Sahap Kavcioglu, a little-known professor and a former lawmaker from the ruling Justice and Development party.
European buyout giant EQT AB’s stock has surged as investors embrace the firm’s bet on U.S. real estate. EQT stock has more than tripled in less than two years since its initial public offering, far outpacing better-known, much-larger U.S. rivals such as Blackstone Group Inc. and Apollo Global Management Inc. The Stockholm-based firm’s planned acquisition of suburban Philadelphia-based Exeter Property Group has helped fuel recent gains. EQT announced the deal in January and expects it to close in the second quarter.
One of the favored examples of investment bubble is the “tulipmania” that gripped Amsterdam in the 17th century. One economist argues that it wasn’t a bubble at all:
The famous tulipmania, which saw the reported prices of several breeds of tulip bulbs rise to above the value of a furnished luxury house in 17th century Amsterdam, was an artifact created by an implicit conversion of ordinary futures contracts into option contracts in an imperfectly successful attempt by Dutch futures buyers and public officials to bail themselves out of previously incurred speculative losses in the impressively price-efficient, fundamentally driven, market for Dutch tulip contracts. There was thus nothing maniacal about prices in this period. Despite outward appearances, the tulipmania was not a bubble because bubbles require the existence of mutually-agreed-upon prices that exceed fundamental values. The “tulipmania” was simply a period during which the prices in futures contracts had been legally, albeit temporarily, converted into options exercise prices.
To sign up for the Capital Note, follow this link.