Welcome to the Capital Note, a newsletter about business, finance, and economics. On the menu today: the bubble puzzle, the lira tanks, and a hot take on tulipmania. To sign up for the Capital Note, follow this link.
Bull Market or Bubble?
Talk of stock-market bubbles has been a perennial feature of the post-financial-crisis world. A ten-year bull market, only briefly halted by the pandemic, has commentators and investors speculating about a sudden melt-up. Recent rallies in Bitcoin and “meme stocks” such as GameStop have brought worries of a speculative mania back into focus.
Famed investor Jeremy Grantham recently argued: “Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behavior, I believe this event will be recorded as one of the great bubbles of financial history, right along with the South Sea bubble, 1929, and 2000.”
A recent Goldman Sachs report, however, argues that the bubble narrative is reductive. I’ll highlight two points that are often overlooked in the debate over stock-market valuations. The first is that most stock rallies are not bubbles. Yale professor William N. Goetzmann finds that the probability of a “correction,” or 10 percent decline, following a doubling in market value is roughly 10 percent. In other words, 90 percent of rallies are real and sustainable. “Bubbles are booms that went bad. Not all booms are bad,” argues Goetzmann.
The next, and especially overlooked point, is that in “winner takes most” industries, such as software, valuations will be skewed to the upside. Consider the ride-share market, in which Uber and Lyft are the main competitors. Investors in Uber are betting that it will take over the ride-share industry and create value in adjacent markets, such as delivery, as well. Investors in Lyft are betting that their company will do the same.
In a world of low marginal costs and potentially unlimited reach, the upside available to companies like Uber is almost unlimited: It can leverage its user base and logistical infrastructure to enter any number of markets. This means that the aggregate value of ride-share stocks may exceed the ultimate value of the ride-share industry once a dominant player emerges. The Goldman Sachs report puts it this way:
Often an innovation attracts many start-up companies, any of which might turn out to dominate the industry, but with no knowledge of which is likely to succeed. As a result, many companies rise in valuation to reflect the possibility of being the eventual winner but with the result that the combined value of all competitors far exceeds the potential profits that the industry…