As semiconductor stocks and the overall technology sector continue a nosedive from all-time highs, investors may question whether its meteoric rise was a “bubble.”
What’s A Bubble?: Bubbles are typically defined by periods where stocks (or other assets) experience price booms substantially above their intrinsic values.
In a bubble, it seems like the only direction asset prices can go is up. Prices continue going up without news or catalysts to drive their upward movement. Their trading activity becomes increasingly detached from valuation.
This price action is usually driven by excitement about a particular industry or company rather than fundamental factors such as earnings or book value. It is easy to get caught up in a bubble. Investors experience a fear of missing out on impressive returns and pour money into companies trading at already-high valuations.
One common cause of bubbles is extrapolation. Investors see impressive returns on particular assets and expect their performance to continue. Of course, betting on continued performance is riskier than it seems. Any market expert will reiterate that “past performance is not indicative of future performance.”
During the late 1990s, the tech revolution sent internet stocks soaring in the “dot-com bubble.” The share prices of internet companies spiraled upward even though many never turned profits. From December 1995 to March 2000, the tech-focused Nasdaq composite index saw 350% returns.
According to Goldman Sachs, in 1990, the value of stocks traded on the Nasdaq was 11% of the value of the New York Stock Exchange. In December 1999, the market value of Nasdaq was 80% of the NYSE. During the peak of the dot-com bubble, Nasdaq stocks traded at a ridiculous price-to-earnings of over 200.
Of course, there is only one way to go from the top of a financial bubble: down. As quickly as a bubble can rocket stock prices to the moon, a bubble can send them crashing back down. Within one year of the dot-com bubble bursting, the Nasdaq shed 60% of its value.
When Do Bubbles Burst?: All it takes is one dent in a bubble for investors to enter panic mode. Panic induces selling, which induces more panic and more selling. And so on. As quickly as bubbles can send share prices shooting up, sell-offs can erase years of gains in just a few days.
It is hard to gauge exactly what event leads to a bubble bursting. In 2000, the burst of the dot-com bubble was linked to high interest rates and Japan entering a recession (perhaps somewhat similar to the market events of today.)
It took 15 years for the Nasdaq to retread its losses from the 2000 bubble.
When bubbles burst, the economic effects are catastrophic. The mid-2000s housing bubble sent housing prices soaring. Lenders offered homebuyers subprime, risky mortgages that could easily default. When the mortgages collapsed, it sent the entire global economy into freefall.
Is The Tech Sector a Bubble?: Ongoing bubbles are harder than they seem to identify but highly visible in retrospect.
While optimism about artificial intelligence is still high, many experts raised “warning flags” on whether AI-related stocks could sustain their high expectations and valuations.
If the tech sector (or semiconductor industry, as reflected in the iShares Semiconductor ETF (NASDAQ: SOXX) continues to post major losses, market experts will weigh defining its ascent as a bubble.
Companies that fall victim to bubbles can still be good investments in the long run, though.
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