Ghosts of Bubbles Past Make Their Return
Whether the gravity-defying price explosion was taking place in tech stocks, real estate or commodities, the bubbles of recent past all carried similar warning signs that signaled the party would soon be coming to a screeching halt.
These common threads included justifying surging prices by ignoring traditional metrics, a false belief that prices would always rise and overestimating the potential of new technologies that connect people.
Watch for these clues in the mushrooming social-networking space as some believe last week’s shocking $9 billion LinkedIn (NYSE:LNKD) IPO signals another bubble is brewing in the tech world.
“People do lose their heads,” said Tom Kloza, chief oil analyst at the Oil Price Information Service. “There’s that herd mentality and there’s always this tremendous bullish bias, regardless if we’re talking about Internet stocks, commodities or housing.”
Shelter as Securities?
The U.S. economy is still attempting to recover from the bursting of the incredible housing bubble, which was created by a flood of credit, a belief prices would never fall and fraud in the financial industry.
At the peak of the bubble, the hottest markets like Las Vegas and Miami were enjoying ridiculous price increases of 3% to 5% a month.
“Houses became almost like securities,” said Richard Sylla, an economics professor and financial historian at NYU. “The places were not even built yet and people were buying them and selling them before construction even started.”
Markets were appreciating in double-digit percentages a year, boosting the incentive to get into the game.
“When everybody and their brother knows real estate is going up by leaps and bounds it’s too late,” said Mike Colpitts, editor and founder of the Housing Predictor.
As the subprime market imploded, foreclosures skyrocketed and home prices suffered enormous declines, evaporating trillions of dollars from the real-estate market. California, Florida, Arizona and Nevada were among the hardest-hit areas, with some seeing prices plunge 85% from their peaks.
“You had people who had no job, no income, didn’t have to verify anything, yet bankers were happy to give them a mortgage,” said Ryan LaRose, a technical analyst at United-ICAP. “That was a sign things had gone too far, too fast.”
The pain infected the rest of the economy and helped cause the greatest financial crisis since the Great Depression.
‘The Great Untethering’
Commodities have also been involved in countless bubbles, highlighted by crude oil surging to nearly $150 a barrel in the summer of 2008 -- just weeks before the collapse of Lehman Brothers that cratered the economy.
At its hottest point, crude leaped by $30 a barrel each month -- a remarkable pace for a market used to gains of perhaps just $10 a year. The price explosion was driven by fears of oil shortages and heavy demand from investors for crude as an asset class.
Yet the price increases didn’t match data that often showed supplies were healthy and the U.S. economy was set to contract.
“They thought the rest of the world wasn’t going to be impacted by this little subprime thing here in the U.S.,” said Phil Flynn, energy analyst at PFGBest and a FOX Business contributor. “I used to get blasted on the air because I said this thing was unsustainable. They thought I was crazy.”
At the same time, analysts and investors used new ways to justify the lofty prices and some made bold predictions for oil to spike to $200 a barrel.
“They start making up new metrics that when you get down to examining them are somewhat suspect,” said Kloza. “Oil really became untethered from the reality of the market.”
Eventually, as the financial system teetered on the brink of collapse, crude oil suffered an epic plunge, tumbling as low as $30.28 a barrel just four months after topping out at $147.
Other commodities have also seen unrealistic price increases, such as the 165% surge in silver between late August and the end of last month to nearly $50 an ounce. Pressured by a return to supply and demand and the stronger U.S. dollar, silver had one-third of its value wiped out in just weeks before rebounding.
Jon Nadler, senior analyst at Kitco Bullion Dealers Montreal, said he saw telltale signs the buying was seriously overdone. “Unemployed youngsters were trading it on their computers and Uncle Harry’s buying it and making a killing,” he recently said.
No Product? No Problem
Some see similarities between today’s craze over social-networking companies LinkedIn, Facebook and Groupon and the inflating of the dotcom bubble.
During that craze just over a decade ago, Wall Street placed unrealistic values on tech companies by overestimating their potential to change the world.
Several companies, such as theGlobe.com and The Learning Company, IPO’d for billions of dollars despite little to no earnings and questionable business formulas.
Investors would say, “Don’t waste my time telling me what they do. Just tell me how many shares you can get me,” said David Menlow, president of IPOFinancial.com. “It was just one ridiculous IPO pricing environment” and a “five or six-year period of insanity.”
The sentiment can be crystallized by the $164 billion marriage of America Online, now AOL (NYSE:AOL), and Time Warner (NYSE:TWX), that has since been deemed one of the worst deals in history.
“You had companies with no assets and no product,” said LaRose, “yet they were trading at 100 times estimated earnings -- let alone actual earnings. It was nonsense.”
Even after 11 years, the Nasdaq Composite remains more than 2,200 points, or 45%, off its all-time closing high set in March 2000. Even blue-chip Microsoft (NASDAQ:MSFT) is worth only about a third of its highest valuation of $600 billion in December 1999.
The dotcom crash followed a string of similar bubbles in history in new technologies that connect people, such as canals, railroads and electricity, said Sylla.
“The great bubbles in history seem to be network technologies,” said Sylla. “The potentiality of new technologies is vastly overestimated. They may not be bad things, but the value gets terribly overstated.”
That brings us back to the current craze over today’s networking technology: the burgeoning social-networking space.
The price tags placed on many of these companies show they are being evaluated based on their growth potential rather than their spotty track records or evolving business models. Analysts and investors are citing the promise of these potentially-revolutionary companies.
For example, LinkedIn received a lofty valuation of $9.3 billion last week and doubled its IPO price in its debut, making it the largest U.S. Internet IPO since Google (NASDAQ:GOOG). Yet the social networking company expects to post a loss this year and made a measly 2010 profit of just $15.4 million, giving it a ridiculous price-to-earnings multiple of 603.
“Whenever people keep telling you this time it’s different,” said Flynn, “that’s when you have to be careful.”
At the same time, social-networking king Facebook is expected to eventually enjoy a $100 billion IPO and daily deals site Groupon has been valued at more than $25 billion.
Part of the craze can be explained by momentum trading or what economists call the greater fool theory.
The thinking goes, “I know I’m crazy to pay $90 or $100 for this LinkedIn stock that just came out at $45,” Sylla said, “but someone else is going to pay even more. There’s a bigger fool out there.”
He added, “You would think people would remember 10 or 12 years ago.”