When Will the Tech-Stock Boom Go Bust?

NEW YORK (TheStreet) -- Many investors would agree that there is now a significant bubble in social media and Internet stocks.

The party continues. Amazon (AMZN) now has a price-to-earnings ratio of nearly 1,000, based on 2015 earnings estimates from analysts, while LendingClub (LC) and Twitter (TWTR) don't even have real price-to-earnings ratios, because both companies are expected to report losses for 2015.

On a fundamental basis, such valuations are only possible if you believe in enormous growth for these businesses' volumes, along with (in Twitter's case) miraculous growth in advertising revenue and the advertizing market generally.

This does not mean, however, that you should sell short these stocks (or at least not yet). The herd driving up the value in these stocks could continue running for a very long time indeed. In fact, one might be foolish to sell short these stocks now, because irrationality in the market often last longer than one might think.

But a tipping point will come eventually. It always does with bubbles. The billion-dollar question is when.

The minds of men are inscrutable and hidden, but one can still come up with some pointers here.

Part of the way to think about this is to look at some of the research that has been done comparing the mass spread of ideas to viruses. See Malcolm Gladwell's Tipping PointRichard Dawkin's "memes" or Robert Shiller's writing in the revised edition of Irrational Exuberance.

What triggers one virus (i.e., ideas interpreted as social viruses) to spread rapidly across society and others just to die out? The mass hysteria around social media and Internet stocks is a virus of one kind, but the inevitable crash (and then likely overcorrection) will also be a mass social virus of another kind.

Remember, most of the investors pouring into these stocks (even at the pre-IPO venture capital stage) have no real clue whether they are investing in transformative businesses.

They are hearing from many others and from the media, however, that these businesses have unique technologies or have "disruptive" features. This is exactly the "conceptual virus" that grips them to buy the stocks.

Of course, at some point another virus will eventually spread like wildfire, pushing the herd to sell these stocks. As Shiller has said, the virus analogy is particularly good for today's world because with modern media, a much wider (and often uninformed) portion of the public is often involved in stock investing.

Shiller argues that this broader group is particularly sensitive to mass communications and hysteria. He says that these viruses effectively crowd the smart money out of the market, and so naturally the market becomes increasingly irrational and volatile. The spread of news due to modern media forms (e.g., the Internet and social media itself) only exacerbates these factors.

So back to the big question: When might the social media crash "virus" hit? Smart investors need to know this, because even though they may be buying these stocks and enjoying the money-making ride on the back of the herd, they want to be out of these stocks before that day of reckoning. Nobody wants to be the last "fool" standing.

It might be instructive to look at the events that triggered the collapse in Internet stocks in 2000 in the light of the virus metaphor. (At the time, the author was working on some of these Internet IPOs at Citigroup (C).)

Gladwell has written that one tipping points can be triggered when information gets into the hands of people who have unique influence over broad public opinion (his "Law of the Few," with the "few" referring to those whom the herd follows.)

Gladwell describes three kinds of of people with unique powers of influence: connectors, mavens and salesmen.

This is instructive, because one of the things that triggered the 2000 Internet collapse was a famous article by the widely respected investment publication Barron's in March 2000. The article showed 207 dot-com companies were badly short of cash. Barron's was, in Gladwell's terminology, a maven. It is no doubt that the article was one of the factors that started to spread the panic, i.e., the anti-Internet virus at that time.

What else happened? Well, at about the same time, the first strong rumors appeared that Microsoft (MSFT) might lose its antitrust case and be labeled a monopoly. The prospect of a Microsoft breakup sparked panic in the Internet community, and the market had one of it deepest plunges on that day. The Microsoft legend was itself part of the lore that kept the Internet bubble virus going. Without it, the virus showed immediate signs of switching direction and becoming a sell virus.

Of course, there is also the wider equity market. Declines in the broader stock market in 2000 particularly ruffled the high-beta Internet stocks, and they went into a free fall. It also starved venture capitalists of exits for their up-and-coming Internet start-ups.

The big established players in today's social media and Internet niche such as Facebook (FB) could survive a significant market correction, although their shares might take a battering for a while. The smaller and mid-sized players are likely to be very vulnerable (that was certainly the experience in 2000).

So the message there was simple: Beware of a turn in the wider market, because highly speculative social media and Internet stocks are likely to take a disproportionate lashing when that turn comes.

It's hard to say when the current boom in the equity market will end, but increases in interest rates are always correlated with downward adjustments in the broader equity market.

None of the above quite solves the problem, but it does provide some clues. In summary:

  • Keep an eye out for a maven (a highly influential commentator) who turns against social media and Internet stocks. That alone might be enough to turn the tide.
  • Keep an eye also on the failure of a major Internet stock that acts as symbol or a pillar of the whole love affair with the industry. For example, if economic conditions worsen, financially exposed stocks such as Lending Club may be particularly badly hit. Default rates on the loans made through its site would surely rise, and the company's online lenders would begin pulling back. Volumes at Lending Club could really decline (whereas it is only huge increases in Lending Club volumes that can justify the current stellar price). If Lending Club's stock price began to collapse, that alone might spook the entire sector.
  • Watch for a broader stock market correction (perhaps triggered by increases in interest rates). If and when it starts, those high-risk social media and Intenret stocks will take a disproportionate beating in the collapse.

So those are a few things to look out for. Perhaps there will be other factors that turn the market this time.

History repeats itself, but never in quite the same way. Remember also, none of these factors might occur for a long time yet, given how long irrationalities can run in the market. But with these hyped valuations, the reckoning will come eventually.

Jeremy Josse is the author of Dinosaur Derivatives and Other Trades, an alternative take on financial philosophy and theory (published by Wiley & Co).

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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