Scott Maxwell: What is the Sound of a Bubble About to Pop?
NASDAQ had its all-time peak on March 10, 2000, when it closed at just under 5,050. The market had been on an absolute tear for several months, having risen from 2,732 the prior October. The world had made it through Y2K, the dotcoms were winning everyone’s hearts and minds, and the last hold-out investors were going long tech.
At the time, I was a fresh-faced venture capitalist extremely excited about the swelling tech industry. I had spent the 80s deep in technology (a couple of tech startups followed by graduate school at M.I.T.) and the 90s figuring out the capital markets (McKinsey & Company, Lehman Brothers, and Putnam Investments).
I was ready. I knew all about technology and capital markets and I was going to spend the rest of my career combining my experiences by funding tech startups and helping them take over the world.
Then the bubble popped.
There was a lot of excitement leading up to March 2000. A mass of entrepreneurs were leaving their jobs and schools to start companies, the venture capital industry swelled with people and capital, small cap mutual funds were hot, and everyone was full of optimism.
Then we had a correction. NASDAQ went from 5,050 in March to 3,322 on April 14. In the minds of many market participants, this wasn’t an issue. While the percentage drop was a staggering 40%, NASDAQ had given back less than six months worth of gains and tech was still the place to be.
Surely, it was just a minor blip in the great technology transformation of the world, right? Through August of that year, it seemed the optimists were correct. NASDAQ bounced around, but went up to 4,232 on September 1, 2000.
Then the market went down, down, and down some more. By April of 2001, NASDAQ had hit a low of 1,720. Interestingly, all the while many people were still predicting a rebound, and I heard a lot of misguided optimism from folks in and around the tech industry. Most felt the correction had run its course and the market would soon move positive. The bubble was popping, but many people did not seem to hear it!
Then the events of September 11, 2001 took place and the market fell further. After a couple of “dead cat bounces,” it was clear that most investors were giving up on tech and the market hit a low of 1,140 on October 12, 2002.
From 2000 to 2002, many interesting young companies did not make it, and those that did had to severely downsize their staffs to save their companies. Many more could have made it if they downsized sooner, but they didn’t hear the sound of the bubble popping.
There was an enormous loss of jobs. Startup employees lost their jobs. Venture capitalists lost their jobs. Tech bankers lost their jobs. We had a period of relative silence in the technology markets.
So how can you tune your ear to hear a bubble coming? When the bubble is about to pop, you usually hear everyone saying things like:
“This market is the best market to invest in.”
“Things are different this time.”
“You have got to go into this market.”
Strangely, the bubble is about to pop right when everyone thinks it’s the best market in the world. At that point, one prick and the bubble will burst.
Why? When expectations spike, capital moves in, which causes prices to go up. When prices go up, many people take notice and their greed makes them want to get in on the action. They buy into the market and push prices up, sometimes beyond what is economically rational. Adding to the fire is that many investors fear missing the market run up, leading them move capital into the markets as well.
Greed and fear: the two most powerful market forces. When market moves trigger the right amount of greed and fear, a virtuous cycle takes over. The markets keep going up unbounded by economic reality.
Further adding fuel to the fire are the market guros who — believing that the market valuations predict the future — reverse engineer the rationale for the markets being where they are. It doesn’t take much; just change some growth rates, monetization rates, and/or lower the discount rate and you have a great reason for the current valuations. Better yet, you can predict even higher valuations!
As more and more people learn about this great market, they start participating. Why not? The markets are going up and the gurus say they will continue to do so. As these people make money in the market, they move money more in and the markets continue to go up. Greed and fear.
Once people move their money in, they also tend to tell their friends. They want to share how smart they are and justify their clever investment moves, so they move money into a market and tell their pals all about it. When everyone moves their money in, it creates a buzz. Next thing you know, everyone is talking about how great the market is and how “this time it’s different.”
At that point, however, there is nobody left to move more money in. With no additional fuel for the market, people start getting spooked and move their money out. Then the markets drop. Sometimes this happens really quickly, sometimes it is a slow-motion pop.Once again, the sound of a bubble about to burst is the sound of everyone saying that the market is the best market to invest in.
At this point, I don’t hear the sound of a tech bubble about to pop. We are seeing a lot of signs of a bubble starting to form, however. Startup activity is accelerating, more people are leaving their jobs and schools to join them, and valuations for some private companies are at levels that seem to be based on extremely positive future expectations.
I hear more people saying things like “things are different this time,” but I also hear a lot of skepticism. When the skeptics turn to optimists, I will hear the sound of a bubble. (And I know how hard it is to resist the temptation to follow the advice of everyone I know!)
So tune your ear. If the current trends continue, a really robust bubble will form and you will eventually hear the sound of a bubble about to pop!
Scott Maxwell founded OpenView Venture Partners in 2006 and has worked in venture capital for over 11 years. For more insight from Scott, you can visit his blog and follow him on Twitter @scottsnews. Opinions expressed here are entirely his own.