Bubble, bubble, toil and trouble if a fragile recovery takes fright

Mon, Nov 18, 2013, 10:21

The European Central Bank has just cut interest rates to a record low, of just 0.25 per cent. Interest rates are similarly depressed, and for some time, in the United States. If – despite the recession blues, the property bubble, and the increases in both direct and indirect taxes – you still have some cash left to save and invest, where might you put it? Well, here’s what some people have just done: they have invested in a new publicly quoted company which is at least three times more valuable than Ryanair; twice as big as Hyundai; and more valuable than Rupert Murdoch’s News Corporation. The thing is, this company has not yet made a single cent, and probably will not do so in any material way until 2015. At the time of the company’s initial public offering (IPO), for every share that was successfully bought, there were 30 other buyers also trying to buy it. The company is Twitter.

Revenue and valuation
Of course, we all know that Wall Street in general values the technology sector ahead of more traditional sectors such as airlines (even if they are low cost), cars, or newspapers and media. But even within the technology sector, the Twitter valuation is very high. For example, Twitter is now valued higher than Yahoo. But for this year, Yahoo is expected to have revenues of about $4.4 billion, and profit of about $1.5 billion.

By the end of next year, Twitter’s revenues are only expected to be about $950 million, with a relatively small profit – less than a quarter of Yahoo’s revenues for this year, let alone profit. Twitter is currently valued at about 23 times more than its expected revenues for 2014, which is more than double the corresponding multiple for LinkedIn and Facebook – both of which arguably are already at very high multiples.

One technology company doth not a technology bubble make. Are the technology IPOs indicative of hyper-inflated expectations? In the US markets, for IPOs raising more than $100 million, the technology sector is currently just in fourth place behind the financial, health care and consumer sectors.

In October alone, there were 32 public offerings (IPOs) in the United States, which is the highest monthly rate since November 2007. Now this month could well exceed this, with 15 IPOs last week alone. There is expected to be a couple of hundred IPOs for this year. However by contrast, just before the dot com crash in the full year 1999, there were well over 500 IPOs.

The deeper concern may be that whether or not we are experiencing a technology bubble, we appear to be experiencing a more general stock market bubble. Interest rates have been relatively low since about 2008, which has encouraged investors to put their money to work elsewhere, and especially in the stock markets. The Standard & Poor’s composite index of 500 large company stocks (not just technology companies) has risen 23 per cent so far this year. The Dow Jones composite of 65 large (mainly non-technology) companies has risen 21 percent. The New York Stock Exchange is up 22 per cent and the Nasdaq by 28 per cent. The London FTSE 100 is up 13 per cent since the start of the year, and Irish Stock Exchange (with very few technology companies) is up a massive 32 per cent.

Purchasing power
There are various leading indicators that caution may now be prudent. In the US, the ratio of the total value of stock markets to gross domestic product is near historic highs. The average price to earnings ratios, compared to average inflation-adjusted earnings, are indicating that stock markets are riding high. The levels of margin debts – a measure of to what extent equity traders are multiplying their positions with borrowed money – are also high as a consequence of low interest rates and cheap money, showing that the stock markets are being leveraged by increased purchasing power.

If there is therefore a technology bubble, it may well be that in fact there is a broader speculative stock market bubble across most economic sectors – whether technology, airlines, cars, news and media or indeed almost anything else.

What then could burst the US stock market bubble, leading to a domino impact on world stock markets? The US federal authorities have indicated that they expect to reduce their “quantitative easing” programme in 2014, by which massive sums have been poured into US dollars (“printing money”) in an attempt to catalyse economic growth in the US. If the US Federal Reserve starts to substantially increase interest rates, then stock market investments will become less attractive. A further trigger to burst the bubble may well be the loss of international confidence in US bonds and treasuries if the value of the US dollar were to fall significantly against international currencies as a result of the quantitative easing programme. A weak and divisive US government system also weakens international confidence.

The US economic recovery, and indeed the global recovery, appears fragile. The strong surge in the US stock markets, including the technology sector, may be more a reflection of easy access to US dollars, leveraging of debt and low interest rates, than any truly significant fundamental improvements. Given our own export-dominated economy, our circumstances are considerably dependent on the health of other economies.

It is a time for steady nerves.

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