Correction is coming but timing unclear
The meltdown in the Chinese stock market and the resulting global stock market chaos have triggered another round of hand-wringing about bubbles, how terrible they are, and what regulators should be doing to prevent their re-occurrence.The technology sector is a favourite whipping boy , especially in light of the surge in valuations of many young technology companies, and there are many who have not only been forecasting the imminent collapse of tech stocks, but will be gleeful when it happens.If you label a market as being in a bubble, you have already classified investors in that market as irrational, greedy and perhaps stupid, and by doing so you have eliminated any chance that you can learn from their behaviour. I do believe that young technology companies are collectively over-priced today but I will hasten to add that is not only a natural outgrowth of markets, but a sign of vitality in markets.Let’s start with the definition of a bubble. A market is not in a bubble just because stocks have been going up for a long period, or they look expensive using traditional metrics (such as PE ratios). For a bubble to exist, the prices that you pay for stocks have to be in excess of their expected values, and the problem lies in measuring the latter, since values have to be estimated and thus are in the eyes of the beholders. I believe that young technology companies are collectively over-priced, but that is just my opinion.
If I think that technology stocks are over-priced, why am I so sanguine about the development? Because it is exactly what you would expect to see in a segment with young companies, going after big markets. After all, each of these companies has a founderfounders and is backed by venture capitalists, but these entrepreneurs and investors all share a common characteristic. They tend to be overconfident and that overconfidence translates into inflated assessments of the likelihood of success and value. Put differently , each startup’s founder and investor base thinks that they have the product that the market will want and values the business accordingly . The end result is that the companies collectively over-estimate the revenues that they will generate in the future and are over-valued accordingly .
To illustrate, consider the long list of social media companies (Facebook, Twitter, LinkedIn etc) that have come into the public market in the last few years, all targeting the growing online advertising market. Just a couple of days ago, I backed out the online advertising revenues that investors are pricing these companies to generate in 2025 and came up with total revenues of $523 billion. So what?
Now you can see why bubbles are a feature of healthy markets, not a problem to be regulated away or to be protected against. They are reflections of the over-optimism and overconfidence that have driven human beings to be audacious, to experiment, and to create change, even though the odds may be against them. A market without bubbles is one without confidence, experimentation and audacity , and I don’t wish to be in such a market. So, I will celebrate this bubble, just as I have other ones in the past, knowing (but not hoping) that it will burst one day , and that it will still change the way we live.
The author is a professor of finance at the Stern School of Business, New York University
Source: The Economic Times
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