One of the curious facts about economic activity is that it leads to bubbles, which burst, and then more bubbles. The Great Depression led to many structural changes in both governmental oversight of the US and other large economies through national banks or reserve systems and through the private banking industries, but we still experience economic bubbles and crashes every 10 years or so. Like Tolstoy’s observation about happy and unhappy families, the growth phases all look very similar — accelerating supply and demand, leading to more and more investment in similar categories — but the bubbles and the bursts are all unique. We can observe the characteristics of bubbles and draw insights about what made them happen, but it is very hard to use those insights to predict when they might burst or what remnants will survive to become new industry leaders.
There have been three significant bubbles in the past 30 years, after the Savings & Loan crash of 1985–6: the junk bond crash of 1990–91 that led to a minor credit crunch and recession, the dot-com crash of 2000–2002 that had a major impact on the tech industry but did not dramatically affect the US economy, and the housing crisis of 2007–2009 that led to the Great Recession.
The junk bond bubble of 1989–90 was a supply-side crash against strong demand; private equity has changed a lot in the last 25 years, but the demand for high yield corporate debt and mezzanine financing is more than 10x today what it was just before the bubble broke in 1989–90. The junk bond market of the 1980s was largely created by Michael Milken of Drexel Burnham Lambert (DBL). Milken worked with two main customer groups: executives from high growth companies below the Fortune 500 who did not qualify to issue “investment grade” bonds, but who were substantially better prospects than the typical small business that gets its debt funding from commercial banks, and corporate raiders or private equity firms who were looking for large debt packages to enable leveraged buyouts. For almost ten years, DBL and their peers showed that corporations outside the Fortune 500 could afford very high interest bond packages, with typical yields of 14–15% and only 2–3% default rates. Admittedly, a lot of the yield was caused by the steady decline in inflation and expected interest rates for all classes of bonds — many muni bond funds and traditional corporate bond funds showed 10% annual returns or better across the 1980s as well.
DBL had run-ins with the Securities and Exchange Commission (SEC) and the US Department of Justice (DOJ) across much of this period as well, and Michael Milken, one of the top executives with the firm, was famous for bending and breaking SEC rules. In 1988–9, the DOJ threatened DBL with an indictment on RICO (Racketeer Influenced and Corrupt Organization Act) charges. The company settled the charges, technically retaining innocence while admitting the government could prove guilt. The company crashed and dissolved in 1990; Milken spent almost 2 years in prison. The pressure on DBL led by Rudy Giuliani for the DOJ essentially stopped the high yield bond supply in its tracks for two years. New debt issues fell from $29Bn in 1989 to $1 bn in 1990, but they recovered by 1992. Since that time, the high yield market has exploded, with significant resets happening briefly with each economic recession (2000, 2008).
The Dot-com boom ran from 1995 to 2000, followed by the Dot-bomb crash from mid 2000 to 2003. This bubble had two major contributing factors: an explosion in venture capital financing and IPOs especially by internet technology and communications companies that led to irrational firm valuations, far removed from the Price/Earnings or Price/Revenue ranges seen in the past 50 years, coupled with a change in the tax treatment of capital gains vs dividends that again pushed firms to issue equity and expand through mergers & acquisitions instead of paying dividends.
In early 2000, the telecom industry published statistics that showed that the exponential growth forecasts for internet traffic had turned out to be wrong (some companies were citing capacity growth, not actual traffic growth), and people started to realize that the “new economy” actually worked under the same financial rules as the “old economy.” Within months, venture funding slowed dramatically and a number of venture firms closed or refocused their attention on just their existing investment portfolio.
The dot-com bubble led to a loss of $1.7 trillion in stock value, mostly by the tech companies that dominated the NASDAQ index. Total valuation fell by 78% between March 2000 and October 2002; the index did not reach its March 2000 peak again until April, 2015.
Of the hundreds of firms that started during the Dot-com craze, Google / Alphabet, eBay, and Amazon have proven to be huge winners. During the 2000–2002 correction, Amazon struggled with showing the value of its business model of reinvesting profits into new growth segments; its stock price fell from a high of $106 in late 1999 to a low of $7.20 in late 2001; it currently trades for close to $970 per share. New giants like Facebook learned from the survivors that market dominance in a category segment is more important than broad coverage across many segments with low share.
The 2007–10 housing market crash had a supply side factor as well as a demand factor. The story of the Great Recession has been told over and over again, but for this analysis, I’ll refer to the growth of sub-prime mortgages across the 2000s, with the mortgage paper repackaged from the junk status that they truly were to a false claim of AAA risk level.
This graph shows is the percent of US home mortgages that were subprime or Alt-A. Until 2003, the fraction of mortgage paper well outside of prime interest rate band was only 10% of total mortgages; even with the higher default level from this class, mortgage buyers were not very exposed to default risk, and they had a good understanding of return levels over time under normal interest rate fluctuation levels. But in 2004–7, the number of new risky mortgages exploded, with developers and mortgage companies putting packages together to attract buyers no matter how unqualified they might have been. At the time, they believed housing prices were destined to climb faster than the cost of money, so it really didn’t matter whether the buyer could afford to pay the loan. The mortgage holder could foreclose and resell the property for more than the cost of the loan.
This growth and crash was caused by “irrational exuberance” coupled with fraudulent packaging of risky loans masquerading as trustworthy baskets of loans, driven by an unstable demand level by a huge group of unqualified buyers that distorted the entire mortgage market for 4 years. The crash in 2008 led to several bankruptcies and bank mergers, and eventually to a completely different approach to mortgage issuance. Subprime mortgages essentially disappeared by 2009, and even the most qualified buyers had a difficult time finding banks and other finance companies willing to offer home mortgages.
So is bitcoin in the growth stages of a bubble today?
The bitcoin market has undergone several huge price climbs and collapses in the brief eight years that this industry has existed. There have been several flash crashes with at least 20% value decline, and the value once fell by more than 80% from peak to trough (Nov 2013–Jan 2015), similar to the collapse of the NASDAQ index.
Bitcoin Price in US$, August 15, 2017:
One of the more remarkable aspects of bitcoin is how fast price corrections happen and how fast they can recover. The most recent crash in early September with a 35% loss of market capitalization was almost certainly caused by the decision of the China government regulators to ban new ICOs and to close exchanges that deal in cryptocurrencies. Several projects simply shut down, and many others have been forced to refund coins or fiat currency invested, at least by Chinese investors. Regulators from several other countries have also been aggressive in restricting ICOs, including US and Singapore. Other country regulators are issuing warnings to citizens about the dangers of investing in blockchain projects.
I see the bitcoin price increase and corrections as being similar to the Dot-com bubble more than any other financial episode in recent memory. There is a huge degree of Fear of Missing Out, with hundreds of tokens being issued to take advantage of this once-in-a-lifetime opportunity to obtain funding for blockchain projects. Like the Dot-com era, few people are doing research to investigate whether the project has any chance of success (Sock puppets to sell pet food and accessories?), or whether a blockchain might actually add any value to some hypothetical solution. The NASDAQ index hit its peak with a combined P/E ratio of 175, nearly 10x the ratio that most investors are comfortable with. Few of today’s token-backed businesses turn a profit, and it is hard to correlate the value of a token with the actual or expected future profitability of the project.
Like the internet of 1997–1999, there are some winners hiding in the crowd of undifferentiated token issuers. Some recent ICOs have resulted in unicorn-level valuations approaching $1 billion for their projects (OmiseGo, Qtum, Ripple Labs), and there are a few mega-project consortiums that oversee dozens of blockchain projects, like ConsenSys.
A new wave of corporate innovators are pursuing blockchain projects as well. While Jamie Dimon of JPMorgan Chase recently disparaged bitcoin as a worthless investment, the firm has been pursuing its own blockchain program called Quorum to enable private but secure transactions among enterprises. Many other large tech companies have similar projects under investigation. It is likely that many of the thousands of projects that are being funded today will disappear within 2–4 years, just as most startups die or are acquired and integrated into other solutions. And it is likely that a handful of blockchain concepts will become category winners and lead to new billion dollar businesses. It’s just a little hard to predict which ones will be the winners right now.
- Wikipedia. Drexel Burnham Lambert — Wikipedia.
- Sober Look. High yield debt issuance in 2012 hits an all-time record
- Credit Slips. QM Impact on the Mortgage Market
- Economist (2000). From dot.com to dot.bomb
- Business insider. Here’s Why The Dot Com Bubble Began And Why It Popped
- NewsBTC. Bitcoin Price Watch; Here’s How We’re Playing The Correction — NEWSBTC
- JPMorgan Chase. Quorum | J.P. Morgan.
- Photo by Alexandre Perotto on Unsplash