There Are No Such Things as Bubbles

Posted by Jeff Carter
on March 28th, 2011

There is a lot of talk about the stock market, and specifically the start up market, being in a bubble again. Ever higher valuations for companies like Facebook, Twitter and Groupon have spooked a lot of people. Are these really serious businesses? Hooking up with friends, tweeting 140 character sentences and coupons are worth big money? It’s news to them.

The answer is that these new business are “real” businesses. The other answer is shelve your fears, we are not in a bubble. Markets may drop in value from here, valuations of start ups may drop, but it’s not because we have produced a bubble. The cause will be that market conditions have changed, and those changing conditions have caused the market to revalue. I am more afraid of what will happen when the Fed stops its stimulus via QE2 than I am of people being overextended by putting their valuable cash into new businesses.

Currently, the cost of capital is cheaper because of Fed policy. Given the choice of the risk free rate of 3.472% or taking a shot on an idea you think you can make a greater return on investment with, what would you do? Investors are rational, and markets are efficient. Even relatively unregulated ones like start up investing. As a matter of fact, investors in start ups are probably the most critical and thorough investors around. They aren’t taking random shots. With the value of the dollar getting cheaper as valued by the forex market, why not put your cash to work in something that can grow faster than the rate of inflation?

We are in the next phase of the internet. The beauty of the new applications on the internet is that they are all virtually a la carte. You can customize anything to how you want to use it. The applications are only limited by your imagination. In the first iteration of applications, it was one size fits all. Now it’s you fitting the app to your size.

Who really knows the future value of where this could go? The answer is no one with any certainty. It depends on how productive these new innovations make us. Capital is efficient. This isn’t dumb money flowing into investments. Many of these new start ups actually have income, customers and provide a lot of value.

Gene Fama has postulated the Efficient Market Hypothesis(EMH). He has not been proven wrong. The numbers back him up. There are a cadre of economists and financiers saying Fama is incorrect, that they can beat the market. But, no one has. Fama also has said there are no such thing as bubbles. He disputes Robert Schiller’s assertion that there was a “housing bubble”. Fama’s answer is if there is a bubble, it should be easy to short it and engage in some sort of risk free arbitrage and make some money. Even the traders featured in The Big Short had to wait a long time to make some money on their trades. Since you can count the number of people that had the foresight to make big money on that trade, it doesn’t prove that Fama’s EMH is incorrect. There is such a thing as statistical outliers.

Luis Zingales wrote a paper a while ago taking a look at the market and EMH. He concluded that if anything, the data of the last few years prove the strength of the EMH hypothesis, not disprove it. Active money mangers as a group didn’t do as well as passive funds from 2008-2010.

Investments in start ups are market efficient too. There is a tremendous amount of information and data available, and there is more networking and information sharing among all participants in the investment cycle. The entire network is stickier and communicates more with each other than ever before. Combine the greater and better information with the fact that there is significantly less leverage in the marketplace than there was in 1999, or 2007-08, and you have to come to the conclusion that the start up investment market isn’t in a bubble.

Besides, if there was you would figure out a way to short it and make money.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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