The “Dotcom 2.0” stock market bubble has burst. What happens afterwards?
Over the past few years, I’ve killed a forest of beautiful trees writing about the madness of what’s going on in the stock market. These trees did not die in vain.
and making decades-long highs served as a bucket of cold water, waking investors up to the fact that a vivid imagination isn’t the only skill required to be an investor. Until recently, investors with the richest imaginations seemed to make the most money, until they lost years of gains to months.
Take the ARK Innovation ETF (NYSE:), the headliner of recent hysteria and until last year one of the best performing funds in the market. He more than quadrupled between the trough of the pandemic and his peak in February 2021. Some companies he owned had business plans that seemed to come from science fiction novels; many would revolutionize the world; most came with science fiction-like (out of this world) valuations.
Cathy Wood, ARK’s fund manager, became an instant celebrity. The media and Wall Street did what they usually do: they hailed her as the next Warren Buffett. The performance of the ARK fund was compared to the then relatively abysmal performance of Berkshire Hathaway (NYSE:), showing that the relatively young, dynamic and forward-looking Cathy had left nonagenarian Warren has-been in the dust.
The better ARK performed, the more money flowed into ARKK (its main ETF) and the more sci-fi stocks it had to buy. ARK often became the largest shareholder in relatively small companies, driving up ARKK stock prices, which in turn drove up ARKK’s net asset value. This created a vicious circle, caused more FOMO for investors and thus attracted more assets, completely separating the shares held by ARK from reality. ARK’s assets have jumped in less than a year, from $2 billion to nearly $28 billion at the February 2021 peak.
It’s easy to pick on Cathy Wood. We should not. His fund was in the wrong place at the wrong time. Above all, if it wasn’t her, it would have been someone else, another fund.
The , just like many other asset classes, was overtaken by a temporary madness triggered by a combination of low interest rates and huge liquidity pumped into the system by Uncle Sam. market was rich in imagination and poor in common sense.
This movie ends in a very predictable way. Higher interest rates have activated a dormant gravitational field in the market. ARK actions turned into horror stories, crashing down on mother earth. Investors who bought the fund at the peak are down more than 70%. All investors who purchased ARK after mid-April 2020 and held the fund are down on their purchase. Since the majority of inflows into the fund occurred near the top, most ARK investors were wiped out.
There is an interesting parallel between the rise and crash of “digital” stocks during the pandemic and the Y2K bubble of 1999.
The market was already frothy in the late 1990s, full of dotcom speculation. In 1999, companies feared that at the turn of the century computer clocks, instead of taking us forward from 1999 to 2000, would take us back to 1900. Although this is only a real risk for older mainframes, this unleashed a tsunami of upgrades. for everyone. It seemed like every Fortune 10,000 company had upgraded their computers to a new system.
The fierce combination of year 2000 fever and the demand created by all the new internet companies that were going to ride the wave of the internet to revolutionize the world (which they did) led to a substantial increase in sales computer makers and other technology companies, dramatically increasing their earnings.
Then the clock turned to a new century.
Tech companies discovered that pre-2000 sales drove future demand forward, and internet companies ran out of other people’s money to fund their profitless growth (sound familiar?). Investors expected hockey stick sales to continue, but instead faced a drop in sales.
Tech stocks crashed.
I’m not just talking about Pets.com here, but real companies like Dell Computer (now Dell Technologies (NYSE:)), Cisco Systems (NASDAQ:) and Microsoft (NASDAQ:). Some have seen their sales decline for a few years and then rise again. This was the case with Cisco; while others, like Dell, saw sales growth pause for a year; and some lucky ones, like Microsoft, saw their sales increase as if nothing had happened.
Investors who held on to these companies waiting to break even had to wait a long time. They didn’t see their prices hit the highs of 1999 for over a decade. That’s how long it took for earnings to reach their 1999 valuations. (Cisco to date hasn’t reached its 1999 peak).
I’ve made this point many times: the price you pay matters, and big companies are also overvalued.
Much like tech companies during the Y2K/dotcom bubble, digital companies (many of which are owned by Cathy Wood’s ARK) received a significant sales boost during lockdown. But sales only tell a small, superficial part of the story. All of these companies experienced a significant readjustment of their cost structure.
When a business is growing at a rapid pace, management can’t help but draw straight or even parabolic lines into the future, prepare the business for continued current growth, hire new people and invest in assets to support future nirvana. As the rate of growth slows, stalls or, God forbid, turns negative, companies are forced to renormalize their employee and asset bases. This causes layoffs. It’s contagious because some of these companies are consuming each other’s products, leading to even greater sales slowdowns for some.
Ronald Reagan said:
“A recession is when your neighbor loses his job; a depression is when you lose yours.
By this definition, Silicon Valley is going through the early innings of a recession or a depression, depending on where each person and each company stands.
Recessions are healthy because they shift the focus of businesses from the outside (growth) to the inside (operations). Prolonged strong growth is not healthy. This creates a lot of inefficiencies, inflating business cost structures.
When the imagination runs wild, many sci-fi projects get funded. As I write this, I see a headline talking about Tesla (NASDAQ:) laying off 10% of its employees. Tesla, ARK’s largest holding company, is likely going back to its roots of building cars and lagging behind humanoid robots.
We can, of course, pray and hope that a bubble will reinflate under these actions. It can happen – stranger things have happened – but history suggests otherwise. Bubbles rarely hit the same group of stocks twice. There’s a psychological reason for this: Holders who got burned on the first ride usually unload those stocks in rushes.
Moreover, it would require inflation to dissipate and interest rates to return to new lows. Again, stranger things happened.
What I think will probably happen
The flow of news from Silicon Valley is likely to get worse in the coming months and possibly years. Digital companies that were loved yesterday and are still loved today will likely see their valuations reassessed and their stock prices fall further. Investors’ affection for them can turn to hatred and then indifference as they move on to other shiny objects.
It’s still hard to see today, but some of these companies will be left for dead. This is what happened to many tech/dotcom darlings in the early 2000s. Some of them will become attractive opportunities; others will fade into insignificance, forgotten footnotes in the history books.
It will be our job to hold our noses and scour future rubble to pick up some darlings from past growth at a bargain price.
Disclosure: Vitaliy Katsenelson is CIO at Investment Management Associates; Its investment strategy is detailed here.