Three bubbles, starting with dotcom

posted: December 28, 2019

tl;dr: Bubbles can be obvious at the time, but fully protecting yourself from the inevitable bursting is hard...

On the verge of entering the 2020s I keep having flashbacks to the most significant New Year's celebration I ever experienced, the rollover from 1999 to 2000. In the common consciousness, which thinks new decades, centuries, and millennia start with a year ending in “0” instead of “1”, it was of course the biggest New Year's milestone I’ll ever experience. More importantly for my life’s trajectory, it was also the tail end of what is commonly called the “dotcom bubble”. I prefer the more precise appellation of “dotcom/Internet/telecom bubble”, but admittedly that takes longer to type.

My post on the trillion dollar beer game describes one way I realized that the industry was in a bubble: supply chain management. There were many other, more obvious (to me) signs.

Paradoxically, one of the signs of a bubble is a widespread mania for an asset class driven by a generally held belief that there is no bubble, that this time things are different. That certainly was true in the mid to late 1990s about all things Internet. It was a unique moment in geopolitical history: the Berlin Wall had fallen, the Cold War had ended, the Soviet Union had collapsed, liberal democracy and capitalism appeared to have triumphed over state-controlled communism, and some were proclaiming it “the end of history”. 9/11 hadn’t happened yet. The Internet had been turned over to commercial companies, and its possibilities to connect the world’s people and information seemed obvious and boundless, albeit not to Nobel Prize winning economist Paul Krugman. Venture capital money flooded in, and almost all companies that had anything to do with the Internet were growing rapidly. The Future’s So Bright I Gotta Wear Shades was receiving plenty of airtime, along with Prince’s 1999.

Broadbandits discussed some aspects of the telecom side of the dotcom/Internet/telecom bubble

Yet at the same time other warning signs were there. I had been exposed to the traditional financial methods of valuing companies while at an executive education program at the Harvard Business School. There was no way possible to make the numbers work for all the dotcom/Internet/telecom companies in totality. Federal Reserve chair Alan Greenspan had also been trained in these methods, and he issued a warning about “irrational exuberance” in late 1996, although it took more than three years for the stock markets to peak. Ultimately Greenspan’s famous comment ended up showing just how long bubbles can persist. For years people mocked him, as they got rich on paper due to the tech stock market boom.

In the small company and startup space, I watched a flood of young dotcom/Internet/telecom companies go public. First it was small, profitable companies going public before they had achieved scale. Then earlier-stage companies with revenue and losses were going public before they had proven they could make a profit. Towards the end even earlier-stage companies with prototypes but no sales and no profits were going public before they had even proven they could sell a product. Day trading was widespread, and stock market investors lusted for IPOs.

I did take some steps to protect myself from the bubble bursting. After returning from the Harvard Business School in late 1997 I realized I had not sold any of the stock I had accumulated in my employer, ADC Telecommunications. I ended up leaving, for other reasons, and cashed out all my stock. Having sold every share I could, and feeling the company was way overvalued, I took out a short position. The bubble, however, persisted longer than I believed possible. I ended up closing out my short position after the stock had doubled from where I opened it. I didn’t want to lose any more money. I bought stock to cover my short not too far from the all-time high, and the price plunged shortly thereafter, once the bubble started bursting. My short position would ultimately have paid off nicely, but I learned the hard way that “the market can remain irrational longer than you can remain solvent”.

I couldn’t fully protect myself from the dotcom bubble bursting because I was in the dotcom/Internet/telecom industry and had no desire to leave it entirely. While the bubble was inflating I co-founded a venture-financed startup company, which ultimately was affected by the bubble bursting. I’ll write more about that soon.

The second bubble I lived through was the real estate bubble which burst in 2008. I couldn’t fully protect myself against that one either because I wanted to live in a house and provide stability for my family. I did avoid speculatively investing in real estate, and I did avoid moving to California, where real estate has, to me, seemed overvalued for decades. From a pure financial perspective I thought it would be safer to own a home in a Midwest city, which was one reason (not the primary) that we moved to the Chicago area in 2005. I did not expect to sell my home 14 years later at a loss, but real estate prices in Chicago have still not fully recovered from the bursting of the real estate bubble.

Will we experience a third bubble in my lifetime? I’ve said for years now that I think we are in yet another bubble: a government-issued debt bubble. Looking at the grim numbers, it’s hard to see how the city of Chicago will ever be able to meet its pension obligations and pay back the bonds it has already issued. Bankruptcy appears to be the only solution. At the federal level, the U.S. deficit grows wildly regardless of which party controls which branch of the government. Everyone is complicit in spending beyond our means. Investors keep snapping up government bonds, even though yields in some countries have gone negative.

The Federal Reserve can just print more money to keep covering the federal debt payments, but devaluing the currency devalues the savings of everyone holding dollar-denominated assets. Printing more money is relatively easy but it’s hard work to increase the gold supply dramatically, so gold offers a refuge from currency devaluations. But you can’t live in a house of gold: it’s an impractical asset. As I’ve learned, it’s hard to fully protect yourself from bubbles bursting.

Related post: I sold my bonds