From the June 2011 issue of Research Magazine • Subscribe!

Facebook Frenzy

Is there a new high-tech bubble?

Until the 1990s, the United States was thought to be a mature industrial economy. Economists were saying that at a mature stage an industrial economy should typically maintain steady if unspectacular growth and its various markets, from real estate to equities, should reflect such stability. Fluctuations from mean are a measure of risk in finance, and wild deviations and frequent boom-bust cycles were expected in places like Hong Kong and South Korea, which were, of course, emerging, rapidly growing economies.

Since the mid-1990s, however, the nature of the American economy has changed and the U.S. appears to have entered a bubble economy stage. Manufacturing, previously the backbone of the economy, gradually disappeared, making that “giant sucking sound” H. Ross Perot famously described during his presidential bid early in the decade. Other sectors became the driving force of the economy and, as a result, economic growth has been strong in some parts of the country and industrial sectors, but weak in others, as well as extremely uneven.

Markets have started to fluctuate wildly, not only in stocks and bonds, but in previously stable residential and commercial real estate. The Dow Jones Industrial Average, a broad financial measure of the U.S. economy, has been gyrating around the 10,000 mark for nearly a decade and a half. House prices, after a spectacular run-up in the early years of the decade, now are back to levels of 2002.

Worse, the entire economy now seems to be growing by fits and starts. One bubble inflates, providing breakneck growth for a while, and then bursts, creating deep recessions not seen during the “mature” stage. It is then succeeded by the next bubble. Currently, there are several bubbles, notably in U.S. Treasuries and in government bonds around the world, where plentiful extremely cheap liquidity has pushed yields on 10-year bonds well below inflation. Commodity prices are also in a bubble stage. While oil prices, for example, continue to climb, Saudi Arabia is cutting output because world demand for oil is falling. This is not how markets are supposed to work.

In stocks, a new mini-bubble is inflating in the social networking sector of the Internet. Valuations of companies have gone through the roof. The leader of the whole social networking phenomenon, Facebook, has gone from around $10 billion less than two years ago to over $75 billion in early 2011. Worse, there seems to be an unstoppable bubble mentality at work. Even though everyone realizes that it is a bubble, there is a buying frenzy that compels investors to keep buying small stakes in top-tier social networking firms at astronomical prices. Even smaller or less well-known ones have been affected. Russia’s search engine Yandex.ru is getting ready for an IPO on the New York Stock Exchange and is being valued at around $9 billion ahead of the sale.

Ready for Yesterday

Some Silicon Valley professionals have started to raise a red flag. But on whether or not it is a bubble, opinion has been sharply divided. While there are some similarities to the late 1990s environment, when dot.com valuations got out of hand, today’s situation is fundamentally different. There are fewer companies involved than a decade and a half ago, when literally hundreds of companies rushed first to the stock market and then on to the bankruptcy court. Today’s social networking operations have a solid business model and are, by and large, making money — some hand over fist. They have not only been able to create solid and durable traffic but found ways to monetize it. There is little evidence of a bubble on the Nasdaq Composite index, which has been trading at no more than 50-60 percent of its 2000 peak.

The problem with this reasoning is that analysts, like European generals in the 19th and early 20th centuries, are always preparing to fight the past war, not the future one. They said in the 1990s that we were dealing with a new economy, with all new rules, and therefore the dot.com boom was not a bubble. In 2008, many economists said that a house was not a dot.com stock and therefore could not decline in price dramatically. Now there are claims that the social networking bubble is not a bubble but a legitimate valuation for the new era of high-speed Internet and an online population of 2 billion people worldwide.

Facebook has definitely drawn a large audience and has some 500 million registered users. It is making money on them, and there are projections that Facebook will soon take over e-commerce and all entertainment. But the high-tech environment is highly volatile. Apple has gone from a pioneer of the PC revolution to a has-been and back to a revolutionary leader in a mere 30 years. And, something like the famous Moore’s law also exists describing the pace of obsolescence of technological ideas and business models in the high-tech industry. Some computer specialists believe that Google is becoming technically obsolete and that it may be blind-sided by some new upstart. Facebook, which is all but seven years old, will need to demonstrate major staying power if it is to justify its current valuations.

However, it may well be true that there is no bubble in the stock market. That’s because Facebook, Twitter, Groupon and other highly successful social networking companies no longer even need to go the IPO route to raise money and to enrich their owners. Thanks to eager investor demand, they can raise billions of dollars without giving up any meaningful portion of ownership. Moreover, the recent reliance on private offerings — where a company doesn’t have to go through rigorous public scrutiny, comply with SEC regulations and be subjected to collective review by the stock market — tends to inflate valuations. And, since there are fewer speculators willing to bet on its fall, as happens in the public securities market, the estimated price of such a company tends to be skewed even more.

In other words, if Facebook shares were suddenly to start trading openly, the company’s market value would probably fall quite steeply.

A Fashionable Thing

It is now fashionable to be a venture capitalist. It is a hip business portrayed in Hollywood films such as The Social Network, and it promises huge returns. Silicon Valley venture capitalists used to be a savvy, passionate and, above all, small group. They had regular dinners together, at which everyone knew everyone else by name, recall industry old-timers. Now at popular Palo Alto restaurants where deals are made, an international babble of languages and accents dominates. And, unlike the old timers, the new globalized crowd consists not of idea men but financiers. They work for sovereign wealth funds, hedge funds or wealthy individuals hoping to dabble in this great new thing.

This is very dangerous. A lot of people with a lot of money who have no idea what they are doing usually tend to lose their money. But that is only half the problem. They will also damage the venture capital industry for others, as well. They introduce a whole new thing into competition: very deep pockets that can buy staying power for companies that would otherwise fold and clear the way for more successful competitors.

That money had already pushed the green-tech alternative and renewable energy sector into a bubble stage, which was followed by a sell-off. Early in 2011, a sell-off in green-tech resulted in a rotation for venture capital funds, which then poured even more money into the social networking bubble. Now, a new bubble is growing in green-tech, following a bout of political turmoil in the Arab Middle East and North Africa.

Not to worry. With the Fed and other major central banks around the world still printing money by the trillion, there is enough cash going around to sustain both bubbles at the same time — at least for now.

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