Irrational Exuberance and "Bubble 2.0"

Yesterday was the tenth anniversary of a statement by one of my favorite people who I don't know personally. My all-time favorite quote from this person is something like:

"If what I just said is perfectly clear to you, then clearly you don't understand what I said."

[statement to a Congressional committee member]

Anyway, on December 5, 1996, in a speech at the American Enterprise Institute's annual dinner, Alan Greenspan uttered these soon-to-be-famous words:

But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions ... We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. ... But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy.

Alan Greenspan
"The Challenge of Central Banking in a Democratic Society"

Many observers believe Mr. Greenspan was wrong about his "irrational exuberance" call (see, for example, Jeremy J. Siegel's commentary "Irrational Exuberance, Reconsidered" in today's Wall Street Journal). Of course, Greenspan didn't actually declare that the stock market was overvalued--he'd never make such a presumptuous statement--but that was how the world understood his comments. For several days thereafter, global stock markets slumped. But then the markets rebounded and eventually an actual bubble occured in the technology sector in 1999-2000.

Jeremy Siegel's article includes some excellent analyses that suggest the stock market was not suffering from irrational exuberance in late 1996. For example, the compound rate of return for U.S. stocks (using the broad Wilshire Index) in the 10 years after Greenspan's speech was 8.2% annually, close to historical averages, and far above the return of other financial investments such as bonds and cash savings.

In addition, Siegel presents data that shows that the 1999-2000 bubble was entirely confined to the technology sector:

From March 10, 2000, when the S&P 500 hit its all-time high, through the end of November this year, an index of all non-tech stocks experienced a very healthy annual return of 8.2%, indicating no overvaluation whatsoever when the popular averages, bloated by the tech bubble, reached their peak.

But the technology sector...

Everyone who works in technology knows that something happened in the late 1990s, and something much worse happened starting in 2000. In Siegel's view, "tech stocks soared in 1999 and early 2000 in wake of the Internet mania and the surge in IT spending associated with the Y2K computer scare."

And when it was all over, young companies were going bust, leaving a great many of their former developers unable to find a job. Sales of computer books fell precipitously (see Tim O'Reilly's Book Sales as a Technology Trend Indicator" and related O'Reilly Radar posts). Consulting rates were halved, if you could find any work. Likewise for computer book editing/reviewing and writing technology articles.

It was a dismal time. For AOL, it was particularly dismal. It was during this period that Jonathan Miller was hired. Over the next several years, AOL was transformed, eventually leading to today's "AOL Is Open" presentment of the corporation and AOL's prominence at the Web 2.0 Summit. Of course, the very existence of dev.aol.com is another aspect of this transformation.

Does AOL's transformation mean we've entered "Bubble 2.0"?

There's a lot of talk these days about Web 2.0 actually representing "Web Bubble 2.0." For the most part, I avoid conversations of this type. People tend to think that whatever happened recently is a good predictor of the future, and it's very difficult to argue against that evidence. Until the forecasts are overcome by events. Subsequently people come to know that you can never trust a positive trend, because it's merely an ominous sign of impending doom, just as it was last time.

This is a primary reason that intelligent contrarian investing can lead to significant long-term profits. The "crowd" is very often wrong about what's going to happen next.

I was surprised to see an article titled "Free AOL Stuff, Courtesy of Bubble 2.0" that appeared in the New York Times on November 16, 2006. The article, written by well-know technology writer David Pogue, starts out like this:

Don’t look now, but the bubble is back.

Yes, it’s 1999 all over again. Web start-ups are cropping up with names like Bebo, Squidoo and Moblabber. Start-ups like YouTube, less than a year old and unprofitable, are being sold for $1.65 billion. And the business plan known as Free has returned. You know, “We lose money on every transaction, but we’ll make it up in volume.”

One of the most surprising participants in Web Bubble 2.0 is AOL, the company formerly known as America Online. On Aug. 2, it announced what might seem to be the craziest business plan yet: a 100 percent price reduction. The monthly membership fee dropped from $26 a month to ... nothing.

Was AOL nuts? Should its executives be dragged away by the nice men in white coats?

In the end, Pogue argues that AOL is offering potential customers a lot of good technology, that it's possible that AOL may not be "nuts." But he warns potential users who are interested in AOL's "freebies" to jump in soon, because "If the last tech bubble taught us anything, it’s that freebies like these don’t last forever." In other words, AOL is offering more for free than we can reasonably expect it to be able to offer into the long-term future.

Ripple, dip, and wave

Among other part-time pursuits, I love reading about economics and the history of innovation. I'm going to close this post (but not the conversation) with an observation, or perhaps a theory, that has come to me through decades (yup, it started long ago) of close reading of the Economist and daily browsing of the Wall Street Journal. Hopefully I've properly digested my lessons. In any case, here's what they say to me.

Technology revolutions that transform civilization generally have three phases: a ripple, a dip, and a wave.

In the ripple phase, something new appears on the horizon. It's new, it's apparently disruptive, but no one really knows its full potential, but everyone knows it's going to transform business and society and the entire civilization. Once everyone knows that, everyone wants to profit. But the technology is still primitive, and while it's cool, integrating it into the existing economy is fraught with difficulty. It's young technology, so it can be unreliable at times. Established businesses are naturally queasy about embracing something so unproven. But, after a period of years, finally everyone admits the new thing is here to stay. Suddenly there's a scramble to not be left behind! And you have a bubble.

Then, after all this money and energy has been invested in the new technology, it becomes apparent that, while indeed the new technology is cool, it's not transforming business and society quickly enough to return a profit on the vast sums of money that have been invested. For example, electricity was a great, incredible, wonderful invention, but could it transform the entire economy operating on a table in Thomas Edison's laboratory? No. Autos were another great invention, around which enormous excitement and investment flowed circa 1897 and subsequently. There were electric cars, steam-powered cars, gasoline-powered cars, everything imaginable. Verbal and financial wars raged over which technology was best and would "win" in the end. But had autos radically changed our economy and society a few years later? Hardly. Instead, there was lots of laughter about horses besting cars in head-to-head races, and jokes about cars breaking down on muddy roads. The great majority of the first manufacturers went bankrupt. A few years after cars were invented, for most participants the automotive industry was a bust.

That's what I call the "dip" phase. And in this phase, a great many people, who invested time and money in that latest technology, only to lose everything, are certain it was all an illusion, the technology "tricked" us.

But, lo and behold, the few survivors of the dip grow and prosper over the coming decades, and the economy and society are indeed transformed. The initial promise of the ripple phase is indeed fulfilled, but it is fulfilled over a period of decades, not in a two or three years where everyone suddenly becomes wealthy beyond all imagination. The technology was indeed revolutionary, it did eventually leave its imprint everywhere in the economy, it became a part of every day life for every citizen. But it happened in a wave that rose and spread over a period of decades.

I could be wrong (that does happen, sometimes), but I think we've now entered the start of the Internet's "wave" phase. I don't think this growth is going to end. Sure, there will be fits and starts. But "Bubble 2.0"? I really doubt that.

Your comments, critiques, analyses of the flaws in my argument, are as always welcome.

-- Kevin Farnham
O'Reilly Media