As the saying goes, “history repeats itself.” Smart investors are willing to learn from the lessons of history’s mistakes. Other investors have lost money in stock market crashes, and we should strive to avoid this.
Throughout the history of the stock market, there have been bubbles that have risen irrationally. Looking back even before the market, people have been shown to at times go crazy in valuing things. In 1637, a bubble known as Tulip mania swept through the people of Holland.
In the middle of the Dutch Golden Age, a simple flower like the bulb of a tulip became highly coveted and considered a luxury item. The price of this tulip rose increasingly higher as more people demanded it. This resulted in a kind of madness that self perpetuated itself, until a single tulip bulb became worth as much as 10 years of an average salary– equivalent to $400,000 today.
The moral of this story comes with its conclusion, as the price unexpectedly and suddenly collapsed and owners were left with a worthless flower. While there seems to be no rational explanation for how this happened, the truth is we see bubbles like this build up and pop many times throughout history.
The bottom line is that people forgot the actual worth of the tulip, and were satisfied with paying high premiums just to get one. Only later did they realize how foolish that was.
The best way to avoid getting hurt from a bursting bubble is by staying away from it. If you can avoid participating in the bubble forming, you will be relatively safe when it finally does pop. The forming of these bubbles never makes sense logically, yet there are always plenty of victims who get swept up in the newest bubble every time.
So while you can’t avoid general market declines, you can dodge massive loss of capital that results from a bubble breaking. In order to do this, you need to be able to identify when a stock is a potential bubble, and most importantly understand why and how these crashes happen.
The How? and Why? of Bubbles
A common characteristic in a stock that crashes is that it first has a magnificent rise in price. Oftentimes, there is so much hype and excitement behind such a stock, driving it higher and higher. As record highs continue to be broken, many people can’t resist feeling greedy and feeling as if they are missing out on this bull run.
So, they disregard basic and proven fundamentals in the assumption that the price will continue to run higher and that they will be able to correctly identify just when to sell for big profits. Even analysts and journalists will get caught up in the momentum and claim that old school valuation metrics don’t apply (example below). Oftentimes these stocks are groundbreaking and revolutionary.
However, in the stock market nothing is really new, and the same rules always apply. Whether it was the airline industry, the television industry, internet stocks, biotech, or 3D printing, all of these industries changed the world in unprecedented ways.
The stock market always recognized this, but it always resulted in overexcitement followed by a crash and reversion to normal valuations. The fact is, all of these companies–groundbreaking or not– are still companies who need to make profits for shareholders. As such, they eventually become subject to the same criteria and fundamentals as other companies in the market. After the dust settles, people see how easy it was to get caught up in the bull and be part of the bubble.
The hype around a stock can cloud everyone’s judgment and make people forget how a company should be valued. Or the whole financial community can get caught up in the bull. Consider the dot com bubble of 1999-2000. During that time, many internet stocks were shooting up to extreme valuations just because the internet was so revolutionary at that time.
People saw that internet was going to change the landscape of commerce, the exchange of ideas, and disrupt long established business models. While none of those things weren’t true, people put too much emphasis on the internet’s immediate effects, especially in the stock market.
The Irrational Dot com Bubble
I found a somewhat disturbing article from the New York Times on January 23, 1999, further reinforcing my argument against mutual funds. The author concluded, as did most of the rest of the financial community at the time, that managers who were using traditional stock picking strategies were losing ground to the averages. Because of this, the editor of the InvesTech Mutual Fund Advisor James Stack said that many “understand that they are paying exorbitant prices for stocks” but that most pros “don’t have a choice.”
This had to have been a huge red flag. Mutual fund managers knew they were paying ridiculously expensive prices for stocks but had no choice other than lose their job for not getting involved in the insanity. Is this how you really want your money managed? And then in the same article, a fund manager named Kevin Landis from Firsthand Funds was interviewed as well.
Having seen much success during this time of speculation, Landis boasted that “everyone freely admits these are not tulip bulbs; the phenomenon is real.” He continued on stating, “But everyone pretty much agrees valuations are silly. A few people are bold enough to predict that there’s a valuation bubble and it’s going to burst, but they’ve been ruinously wrong.” Oh, how wrong everything he said really was.
As was the case with the tulips, the internet stocks that soared to new heights in 1999-2000 crashed quickly to the floor, leaving everyone in the dust. Fund managers like Kevin Landis saw their funds get destroyed and go bankrupt, and the shockwaves of the next bear market were felt throughout wall street.
Like every big bubble, the dot com bubble had its day, but it eventually ran out of time. And characteristic of every bubble, most people weren’t able to get out in time and got left with catastrophic losses. Normalcy finally returned, and people remembered the standard rules of valuing companies and wondered why they were ever so foolish to make exceptions with the internet stocks.
I have two more examples of companies whose valuations got out of control in the dot com bubble. Take careful note of the stark similarities to Tesla today, which I will refer to later on as well.
InfoSpace: A “Special” Case
During the internet craze, many wireless and communication companies saw extreme stock price rises as well. A company called InfoSpace saw huge increases in particular, due to its communication infrastructure services to Websites and other merchants, among other things.
Now, the valuations for InfoSpace went sky high along with other internet stocks. As high as the price went, it eventually crashed like every other internet stock. However, as the price was dropping people didn’t lose all hope just yet. There was an article in the New York Times on September 23, 2000 by Mitchell Martin called, “Amid the Wreckage of Internet Stocks, a Pair That Merits Another Look.”
Martin was referring to Infospace as one of these companies, and claimed the stock was still promising because it had marginal earnings, unlike other dot com stocks that didn’t have earnings. Note the use of the word marginal here. What he is really trying to say was that InfoSpace didn’t have positive earnings either. In fact, they had negative earnings in 1998, 1999, and 2000.
Yet the impact of the bull market still fogged his vision, as he was making up new terms to make the stock sound good. Marginal earnings? I’ve never heard any respected analyst value a company based on marginal earnings. I care about real earnings, as does the rest of wall street. Anything other than that becomes purely speculation.
The author added that there were other analysts who had buy ratings on the company, because of things like expected revenue growth and optimism with the marginal earnings. These buy ratings never panned out for InfoSpace, as the company continued to lose money and the stock price dropped in half and stayed there.
You can’t make sound investment decisions based on predictions and analysts estimates. The sheer amount of error in analysts’ estimates would make you sick to your stomach. Earnings estimates, revenue estimates, and growth estimates are more often than not found out to be WRONG. Yet so many investors invest in a growth based strategy assuming these estimates to be facts.
It may be fun on the way up, but even the smallest miss of these estimates can result in big losses for investors. This is one of the reasons why I don’t invest in these kind of growth stock companies.
One final example for you today. I’m going to look at a company that I actually own in my portfolio now. It’s a great company with an outstanding future. But it was a terrible stock to buy in 2000. I’m talking about Microsoft (MSFT).
“Spectacular Story” Stock
Back in 1997, 4 guys banded together to raise $35 million to start their technology company. Their goal was to provide computer networking services.
With the dot com boom, any technology company of this sort was looked at favorably. We were in an age like no other, with stocks in the technology space reaching all time highs never seen before.
The company became one of the most profitable investments by a financial institution in 90s. It grew from 150 workers to 14,000 workers in just a couple of years.
A company that grew that fast had to be a great investment right? Wrong. The company would file for bankruptcy in 2002, leaving investors with nothing. Global Crossing (GLBC) was the name.
What about a company that was built during the invention of the telephone? From the company that manufactured the first fire alarm box, switchboards for World War I, phone toll systems and more, meet Nortel (NT).
The company had been around since 1895. To say that people relied on their products and services would be an understatement. The company was a constant presence in communications like Google (GOOG) is today.
When the internet came along the company never broke stride. It started selling fiber optic network gear, and investors loved it. They saw the brightest future for the company.
Fiber optics was the newest technology of the time, and it’s scope was seemingly endless. With the popularization of televisions, computers, and other technology, this was the future.
Investors expected growth above and beyond what had ever been imagined before. All of this new exciting technology bursting into the seams was seemingly sure to change our world forever.
Investors weren’t just confident about it, they were convinced. Nortel became so big that it accounted for more than a third of its whole index in market cap (in the TSX index).
An immaculate story stock if I’ve ever seen one.
Guess what happened next? The company went bankrupt. Bankrupt. The leading technology story of its time, and just a few years later it was thrown into the bankruptcy courts. In 2009 to be exact.
Final Example: Microsoft (MSFT)
At around the peak of the dot com bubble, Microsoft (MSFT) had an astounding market cap of $572 Billion. [I use market cap instead of share price in this example because the company had a stock split in 2003].
Internet stocks were all the rage, and Microsoft (MSFT) was benefiting from this craze as well. Microsoft was in almost every desktop computer both at the workplace and at home, so it must’ve been a good stock to own, right? I want to tell you that this is farthest from the truth.
In fact, the stock has never even gotten close to that peak ever again. It may in the future, but for the 13 years to follow a stockholder who bought in 2000 is still facing substantial losses.
At the time of Microsoft’s peak, the stock had a P/E of 60.7. The price to book at that time was a P/B of 13.8. Even Microsoft, the company that dominated the world for some time, fell to normal valuation rules eventually. These kind of extreme valuations aren’t sustainable, and it’s how investors get killed.
It sounds simple to do looking back with hindsight, yet the market never learns. Look at Tesla’s valuations (2020) and compare it with Microsoft, they’re much worse! People forget the lessons of history’s past, and this is why history repeats itself.
I hope you don’t take my warnings lightly. I hope if you’ve stumbled across my article I’ve saved you from future heartache. I don’t know when the top of Tesla will happen. It may even double from here. But remember that this type of thing has happened before. The crash will blindside investors. Bubbles always pop, and the average investor is always the one left footing the bill.
Stay away from Tesla. Let the market correct its valuations. It will happen. Again these are great companies but with absurd valuations. This bubble will pop. Don’t be caught in the splash zone.