Stock Market Bubbles: Beware The Positive Black Swan

 |  Includes: DIA, QQQ, SPY
by: Mike Mask

I am going to take a brief look at a few revolutionary technologies - all Black Swan events, to hopefully give you a sense that great stock market bubbles typically involve a Black Swan technological breakthrough, which has broad implications spanning across many different industries.

The new technology is always incredibly important, and because it was unexpected and because market participants have no clear way of fully understanding the potential implications for the breakthrough technology, it leaves the doors wide open for speculation. As old hat valuation techniques are thrown out because "we're living in a new economy", investors' minds are able to run away from them by imagining the seemingly limitless potential of the new technology - and then they value their imaginations rather than the actual companies.

I will examine three important technological breakthroughs, which fueled three enormous stock market bubbles: the electricity boom of the 1920s, the electronics boom of the late 1950s and early 1960s, and finally the Internet boom of the 1990s. Afterwards, I will explore some future technologies that I believe are of the sort that they could fuel a "new era economy" mentality.

The electricity boom

Jeff Bezos (founder of (NASDAQ:AMZN)), in his fantastic TED talk on "the electricity metaphor", points out an advertisement from Sears dating back to 1917 which read:

Use your electricity for more than light!

The electricity boom really picked up steam at the end of the nineteenth century, but initially it was largely confined (in the commercial sense) to replacing kerosene lamps with electric lighting. In the early twentieth century, many first adopter products with incredibly diverse applications for electricity were being invented - Bezos cites the example of the first vacuum cleaner: the 1905 Skinner vacuum which "weighed 92lbs, took 2 people to operate, and cost a quarter of a car". And just three years later it weighed "only" 40lbs.

Electricity was now being used to enhance lives in ways never before imagined: electric washing machines saved untold hours of vigorous labour, electric fans enabled people to be cool in the summer without any effort, electric iceboxes revolutionized food storage. Not to mention the electric radio, electric iron, and many, many more inventions that reshaped how people lived. It's impossible to do, but try to imagine living during a time when none of these devices existed, and then suddenly in a very short number of years, your entire way of life being disrupted and modernized by these amazing new products.

Americans were truly living in a new era economy in the 1920s. By 1930, due to Ford's mass production assembly line dramatically lowering the cost of production, well over half of all American families had a car (imagine how dramatic an impact this would have been!). And if it wasn't obvious enough during 1900-1920 that electricity was about to shake up everything, it was by the 1920s, as these inventions had started to become affordable to mainstream consumers. Furthermore, American industry was benefiting from the demise of Europe's industrial base during the First World War, which meant that Europeans now had to rely on American enterprise for much of their goods.

All of these positive tailwinds convinced speculators that "things were different this time" and that the country had moved into a new technological period in which boundless prosperity was both inevitable and rapidly approaching. Valuations on companies, particularly anything involving electricity, shot through the roof as old valuation metrics such as looking at earnings, revenues, and hard assets "could no longer be applied" to these new age companies with a near infinite scope for expansion. Electricity was making its way into just about every industry, moving and shaking the entire economy.

Like the Internet boom of the late 1990s, the electricity boom of the 1920s fed a rapid expansion in the stock market.
-Gene Smiley, Marquette University

Electricity was revolutionary, but the euphoria of the stock market outpaced the electric revolution. Companies like General Electric traded at $396 per share at the peak of the bubble in 1929, which represented over 40 times earnings, and over 700% of book value. When it dawned on stock market participants that boundless prosperity was not on our front doorstep, the price of GE collapsed to just $34 a share three short years later.

The electronics boom

In 1954 the first transistor that was able to be mass produced had been invented - a transistor is an immensely important technology that regulates the flow of electricity much like a light switch that can turn on or off. The invention of the transistor enabled another extremely important discovery: by 1958-1959 Jack Kilby of Texas Instruments and Robert Noyce (co-founder of Intel) independently invented the integrated circuit (a very complicated electric circuit).

Now technically speaking these inventions were planned, and therefore not true Black Swan events - but I don't think anyone at the time could have comprehended the scope of what they eventually gave rise to: inexpensive supercomputers that fit inside your pocket and have instantaneous access to all of humanity's knowledge, to paraphrase Elon Musk. Because the outcome of these events was unplanned and unexpected, I still think of the mass produced integrated circuit as a Black Swan event in human history.

The integrated circuit paved the way for the "electronics boom" of the late 1950s and early 1960s. Suddenly electronic devices could be miniaturized and cheaply mass produced. Solid state amplifiers, transistor radios, calculators, and eventually the first personal computer to be unveiled by Steve Jobs and Steve Wozniak in 1976 all came into being because of the integrated circuit.

High flying stocks during this bubble, many trading at 100-200 times earnings, almost all had "tron" or "onics" in their names according to Princeton economist, Burt Malkiel. Examples include: "Astron, Dutron, Vulcatron and Transitron … Circuitronics, Supronics and Videotronics … as well as one company that, for good measure, put together the winning combination Powertron Ultrasonics."

The euphoria in the stock market around this time eventually gave way to the "secular" bear market ranging from the mid 1960s to the early 1980s, in which nominal stock prices remained stagnant, and real stock prices (meaning stock prices adjusted for inflation) actually declined.

The Internet boom

The U.S. Department of Defense unwittingly started the Internet in the 1960s by building the precursors to it in a project intent on developing communication systems using computers. Estimates of when the modern Internet came into being appear to converge around the mid 1980s.

Those of us who are old enough to remember what life was like before the Internet will deeply know how revolutionary it has been (and I am just barely old enough). I will quote an excellent passage from Wikipedia describing some of the many changes that the Internet has brought about:

Since the mid-1990s, the Internet has had a revolutionary impact on culture and commerce, including the rise of near-instant communication by electronic mail, instant messaging, voice over Internet Protocol (VoIP) telephone calls, two-way interactive video calls, and the World Wide Web with its discussion forums, blogs, social networking, and online shopping sites.

Whenever I sit back and "zoom out" to really think about what the Internet is, how amazing it is, and how I would attempt to explain it to humans living 1000 years ago, or heck even 100 years ago, the hair on the back of my neck always stands up. Here's my attempt to explain it, and note that I am not qualified to be speaking about physics, this is simply a thought experiment.

"Well you see, the Internet is like this virtual space that you can tap into with this little box *pulls out cellphone* that contains all of humanity's information. Every song, fact, video, book, monstrosity or inspirational aspect of humanity is all there. It all sort of invisibly floats around the world in the form of electromagnetic radiation (waves of light) and this contraption *holds up cellphone again* can instantly detect the information you wish to receive based on the frequency of the vibration of the light waves."

Think about it. You have the ability to transmit light waves to the other side of the planet and have them magically reconfigure on someone's screen so that they can see you, and you can see them, and the two of you can have a normal conversation without even thinking about how insane what you are doing is.

Furthermore, the drive to have access to the Internet at all times has led to a tremendous amount of innovation. Just 20 years ago the computational power contained in a modern smartphone would have taken up multiple rooms of storage space and cost tens of millions of dollars to build and maintain. Now it costs $300 and fits in your pocket - and is vastly more powerful than the technology NASA used to land people on the moon.

So once again, Americans living throughout the Internet boom really were living in a new era economy. In the spring of 1994, Jeff Bezos claims that Internet usage was growing at over 2300% annually. The Internet changed, and is changing everything. I believe we are still in the early phases of figuring out how we can apply the Internet to make our lives much better. Virtual reality podcasts and business conferences? Apps that lead you directly to the store, and then the product you wish to buy when you are in the mall and then allow you to simply scan your phone or watch? These are just a couple of ideas. But as is the common theme so far, the euphoria of the stock market outpaced the actual revolution that was going on.

This is the time period when former fed chairman Alan Greenspan so famously described the valuations that were going on in the stock market as "irrational exuberance". The average price to earnings ratio on the S&P 500 reached the mid 40s, about three times the historical average. McKinsey et al. show that analyst earnings expectations for the future were roughly 50% higher than both the near and distant historical growth rates would seem to imply.

Any stock with ".com" in it soared. Tales of college students making hundreds of thousands of dollars by buying Internet stocks, or starting simple Internet ventures ran rampant. Dr. Daniel Crosby, a behavioral economist who runs (and a personal hero of mine) cites the example of the relative valuation between two toy stores during the Internet boom in his great TED talk on behavioral finance:

Toys "R" Us, a traditional brick and mortar business had revenues of $11.2 billion, profits of $376 million, and a market capitalization of $6 billion.

Another toy store,, had $30 million in revenues, was losing $28.6 million a year, but somehow maintained a market capitalization of $8 billion - over 30% higher than the valuation of Toys "R" Us, despite the fact that was earning a fraction of 1% the revenues that Toys "R" Us was earning.

Again, companies were trading at hundreds of times earnings right before the general public clued in that despite the revolution that was the Internet, profits still matter. The Nasdaq eventually lost nearly 80% of its value in the crash that ensued as greed turned to fear and boom turned to bust.

The future boom?

What do these three examples have in common? A very important and revolutionary technology changes the entire economy and excites the masses and always leads us to overestimate how large its impact will be. There will come another day (unless we are hit by an asteroid, plague, nuke, etc.) when some new Black Swan technology promises to revolutionize the entire economy. Since I am attempting to predict (for fun) some technologies that I think could spark a "new era" mentality in greedy stock market participants I will describe these events as Gray Swans (rare and impactful events which can be somewhat predicted).

Perhaps it will be 3D printers revolutionizing the entire manufacturing industry and completely transforming home life: imagine printing off your utensils, keys, replacement parts, designs, tools, etc. on demand.

Or, perhaps it will be miniaturized drones and robots flying our Amazon packages around, cleaning our houses, making our coffee, flipping our burgers (especially if fast food strikes over higher pay continue).

Maybe gene mapping and biotechnology will lead to new forms of organisms capable of cleaning up oil spills, reusing nuclear waste, personalizing healthcare and eliminating many horrendous diseases through targeted gene therapy.

Since the cost of solar power appears to be declining at a geometric rate, and since Elon Musk's Tesla promises a lifetime of free energy after one buys a Tesla vehicle, maybe the world will once again become awash in cheap energy. This could change everything.

Whatever happens, history is pretty clear that at some point in the future (again, barring catastrophe), a new technological breakthrough will promise to shake up the very foundations of our economy. When it hits us, we will all be tempted to throw caution (and standard valuation metrics) to the wind in order to participate in the "new economy". But don't be fooled. Keep in mind that the story you are witnessing has been told again and again throughout history, and that market euphoria inevitably outpaces the actual revolution that occurs. The Internet has changed everything about modern life, but that didn't stop investors in the Nasdaq from losing everything when it collapsed by almost 80%.

Disclosure: No positions