Have you heard of the Austrian business cycle theory (ABCT)? Not many tech investors have. It implies that their successes, when they happen in clusters, have nothing to do with technology at all.
The 2000 tech bubble wasn’t about the internet or computers. It was about monetary policy. At least that’s what ABCT claims. It’s a bit like the tide and rowing. Sometimes looking at the shore is a misleading evaluation of how fast you’re going.
Of course, individual tech investing success stories are very real. Like this one. But it’s bubbles that inflate the price of all tech trends at the same time which should make you suspicious about what’s really going on.
ABCT believers claim that the business cycle, and investment bubbles, are caused by central banks. The 2007 housing bubble being the textbook example. House prices are especially sensitive to interest rates, so that’s where bubbles tend to happen when central bankers get it wrong.
People who believe in ABCT have always had a weakness in their dataset. If central banks are causing the business cycle, not smoothening it, then what happened in the tech boom of 2000? How did we have an asset price bubble of incredible proportions back then, without quantitative easing (QE) or ridiculously low interest rates to finance it?
Well, it turns out that there was a large expansion of the money supply back then after all, in the form of something called repos. Today, you’re going to learn about what they are and why they matter. In short, they cause tech bubbles. Tech bubbles like 2000 and the one you’re in now…
But are we in one? Or is our latest boom in tech stocks perfectly rational?
Well, the per cent of US initial public offerings (IPOs) which are money-losing enterprises is at a peak not seen since 2000. And the US’ S&P 500 index has diverged from its earnings in a way we haven’t seen since, you guessed it, 2000.
Those are the two commonly known pieces of evidence for a tech bubble.
But recently, Barron’s magazine exposed another one. The similarities in monetary policy between the tech bubble and today:
Is the Federal Reserve letting the stock market party like it’s 1999?
Several savvy observers see similarities between shares’ recent levitation on the heels of the central bank’s aggressive provision of liquidity to calm the repurchase-agreement market and the days when it pumped in billions to stave off the looming specter of Y2K and, in the process, inflated the dot-com bubble.
In the late 90s, central banks were worried about the Y2K bug. The idea that computers would fail to tick over when their dates hit “00”. Planes would fall out of the sky and stockmarkets wouldn’t even be able to crash as a result.
I used to laugh at the idea. But at the time, one of our successful newsletters from our sister company in the US was all about how to prepare for the Y2K bug crisis…
Years later a family friend who had been the financial director of Harrods at the time told me how much the firm had spent on making sure nothing went wrong at midnight on 31 December 1999. I realised it wasn’t a joke at all.
But here’s the point in all this. The Federal Reserve inflated the tech bubble in 2000 in precisely the way it is inflating the tech bubble right now.
Except in Europe, where the European Central Bank is busy inflating a housing bubble in Germany instead, just as it inflated the housing bubble in Ireland and Spain in 2005.
We’re calling it the Twin Bubbles hypothesis. More on that in coming weeks, no doubt…
But back to repos and how they cause tech bubbles. The broad answer is simple. Tech companies tend to not be profitable. Their CEOs would add “yet”.
So how do they sustain themselves? By raising money, in two ways. Listing on the stock exchange and borrowing money. Lower interest rates and more available money allows more money losing tech companies to be “viable” for longer. And it allows their stock to outperform by reducing the need to issue more shares in capital raisings.
Simple. But what’s this repo business got to do with it?
Repos are the sort of thing you learn about in your last semester of a finance degree. And things get complex, but here are the basics…
A repo is a repurchase agreement. It’s an agreement to sell someone something, while also agreeing to buy it back at a later date. Usually for a slightly different price.
The effect is similar to a loan, but in the form of an agreement to sell and repurchase something. The emphasis is on the cash changing hands temporarily, not the asset that’s being exchanged.
Normally, central banks lend money to other entities and require those entities to pledge collateral to secure the loan. A bit like you mortgaging your home with the bank. If you don’t pay up on the loan, the bank takes your home. That makes lending very safe. Central banks usually demand the same sort of security from banks.
A repo is much the same, but the collateral is actually sold instead of just pledged as collateral. This makes repos a marginally safer way for central banks to lend money because, if there’s a default, they already own what is really just the collateral. It doesn’t look like a loan, but that’s its real and intended effect. It’s just a bit safer.
When a central bank provides repos, it is lending money into the market in exchange for an asset. It’s a bit like self-cancelling QE because, when the repo expires, the transaction automatically reverses. But central banks just keep rolling them over, making this self-cancellation a technicality.
The point is that repos are like QE – they’re inflation of the money supply, in effect if not technically. And inflation of the money supply is what causes investment bubbles according to ABCT. That’s what happened in 2000 to fend of the Y2K bug and it’s what’s happening now.
The Wall Street Journal’s headline from last week put that on display:
Fed Adds $82 Billion to Financial Markets
Banks’ demand for longer-term liquidity increases in latest repo operation
There’s a debate on about whether repos amount to QE or not, but that’s irrelevant. They caused a tech bubble in 1999 and they’re doing it again today.
If your tech portfolio is looking suspiciously good, you need to think about why. Is it because the Fed is pumping money into financial markets, or is it because the future is extraordinarily bright for an unbelievable portion of your portfolio?
Not that you need to give up on whopping speculative gains. It’s just that they’re about to happen elsewhere – in the polar opposite part of the stockmarket to tech.
Until next time,
Editor, Southbank Investment Research