Soros And The Second Coming Of The Dark Fiber

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Includes: AMZN, CSCO, FB, LNKD, RAX, TWTR
by: Paulo Santos

Summary

As with the dotcom bubble, today we're seeing an investment boom in technology, part of which can be explained by Soros' theory of reflexivity.

This means that as the bubble goes away, which seems to already be happening, a good part of that technology demand will also go away.

In the present case, the "dark fiber" of today seems to be cloud services, so Rackspace and Amazon.com are particularly vulnerable to this dynamic.

During the 2000 dotcom bubble, an investment boom took place. Part of this investment boom was in telecom capacity, namely optical fiber capacity. So much investment took place in this sector, that a lot of the laid-down fiber went unused. Unused optical fiber was called "dark fiber".

This investment boom can be explained through a theory penned by George Soros. This theory is the theory of reflexivity. In it, Soros explains that the market participants' views of reality influence reality. Put another way, the prices securities trade at in the market, discounting their own prospects, end up influencing those same prospects.

In the case of the dotcom bubble, the fact that tech companies traded at huge valuations led to a short-term virtuous cycle. The cycle was such that the huge valuations attracted investment into new tech ventures, and the new tech ventures needed to buy technology services and capacity, further validating more investment into them, as seemingly, there was a lot of demand.

Of course, when the tech bubble burst, the cycle ended. Investment in new tech ventures plunged, and with it, so did demand for technology services and products. This effect was so strong that even a behemoth like Cisco (NASDAQ:CSCO), growing by leaps and bounds up until the year 2000, actually had contracting revenues by 2002.

Why is this relevant now?

This is relevant because we're going through a similar process right now. Not of the same magnitude, because telecom equipment required more investment, but of the same nature.

And indeed, over the last couple of months, we might already be seeing the deflation of this second bubble. Major participants like Amazon.com (NASDAQ:AMZN), Linkedin (NYSE:LNKD), Twitter (NYSE:TWTR), Facebook (NASDAQ:FB) and others are already significantly lower. These stocks have lost 27%, 45%, 57% and 19% from their highs, respectively. And many other smaller stocks were punished even further.

With this plunge, it's likely that the IPO market will start freezing. And without an easy exit strategy, it's likely that venture money will stop flowing. And with the stopping of that flow, demand for some technology services and products will be severely reduced, as well.

We just have to think about what will be the dark fiber of present times. I can already see a candidate: cloud hosting services. With less investment in the unprofitable Boxes of today, these won't be able to pay their cloud services for long. Yet, massive investments took place to be able to provide those cloud services. These investments are not likely to be recouped.

So who will end up being penalized because of this reflexive moment? I can think of two equities which will see some grief: Rackspace (NYSE:RAX), a pure cloud provider, and Amazon.com, the leader in providing cloud services. This development will be particularly ugly for Rackspace. As for Amazon.com, it will simply interfere with the growth story around cloud services. Amazon.com is diversified, so the overall impact is more on a psychological level.

Conclusion

Same as with the original dotcom bubble, the present bubble valuations led to higher demand for technology services and products. This was to be expected, as per George Soros' reflexivity theory. Now the removal of the bubble valuations will remove part of that higher demand for technology services and products, exposing the excess investment borne by the companies supplying that excess demand.

This seems to be particularly evident in cloud services, so I'd expect companies like Rackspace and Amazon.com to be penalized in the coming quarters due to the implosion now taking place in overvalued technology stocks.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have options positions which stand to gain from AMZN going down.