Harvard's Justin Fox explains the three levels of bubble danger
Posted on Harvard Business Review: June 9, 2011 2:38 PM
If you've been wondering whether LinkedIn's stock—selling as I write this for about $72 a share, down from a high of $122.70 during its first day of trading May 19—is (or at least was) in a bubble, Robert Jarrow, Younes Kchia, and Philip Protter have an answer for you. The trio (respectively, a finance professor at Cornell, an applied-math Ph.D student at the Ecole Polytechnique, and a statistics professor at Columbia) developed a statistical technique for detecting bubbles that they tested on data from the dot-com heyday.
Jarrow, Kchia, and Potter then plugged in LinkedIn's minute-by-minute stock price movements during its first week of trading. The result: "In the case of LinkedIn, the volatility function is well inside the bubble region. There is no doubt about its existence."
This is the kind of thing that can drive people outside of quantitative finance a little crazy; there's no reference to company fundamentals, just "sophisticated volatility estimation techniques combined with the method of reproducing kernel Hilbert spaces." Still, it's encouraging to see finance wonks paying serious attention to bubbles, which for decades got almost no attention in academic finance because they weren't supposed to exist. It's also encouraging to see smart people enlisting the methods of other disciplines in the service of bubble detection.
Now that we're almost all agreed that bubbles do exist, and that they can to some extent be detected as they happen, the interesting question is what to do about it. There's been lots of debate over how central banks should react to bubbles. But what about at the level of the corporation? What should executives do when their company is caught up in a bubble?
As best I can tell, there are three levels of bubble danger (they correlate somewhat with Hyman Minsky's three stages of economic danger: Ponzi, speculative, and hedge finance).
The Ponzi bubble. It's not just an asset-price bubble; it's an asset bubble supported by borrowing that uses those very assets as collateral. And that's not all: Those who've done the borrowing don't have enough income to make the interest payments on their loans; asset prices have to keep rising to keep everything from falling apart. A lot of U.S. mortgage borrowers got into this situation from about 2004 through early 2007. As you may have heard, it ended badly. My sense is that any company that finances itself this way is a fraud, so the best advice for executives is probably turn yourselves in.
The speculative bubble. This is where you keep selling assets (or borrowing against them) to pay your bills, but are working toward a situation where you don't have to anymore. It's okay for you if asset prices stop rising, but if they fall dramatically—or if the market for them simply stops functioning—you're in big trouble. This was to a certain extent what hit Lehman Brothers and Bear Stearns in 2008. They counted on being able to roll over their debt every day, and then suddenly couldn't. But the better example is that of the dot-coms. Dozens of them were able to finance rapid, cash-burning growth in the late 1990s by selling highly priced stock. Then, on March 20, 2000, Barron's published an article listing 51 dot-coms that would run out of cash within 12 months if they weren't able to raise more money or dramatically cut their losses. Market sentiment shifted (possibly because of the Barron's article), the prices of Internet stocks tanked, and within a year or two most of the 51 were no longer with us. This is clearly a risky way to do business. But sometimes it works out: Amazon.com was on that Barron's list of 51 (and its stock price finally climbed back to and surpassed its dot-com era peak in 2009). Markets gave Amazon, an early mover, enough time to build a formidable business, and its management had clearly thought about the possibility of a stock-price drop, and was able to quickly ratchet back spending and turn a profit when it had to. From the evidence of the IPO prospectus it filed last week, Groupon is playing this speculative finance game (it lost $456 million last year, and has $118 million cash in the bank). Does it have a plan for when the flow of cash from investors dries up? The signs aren't all encouraging.
The plain old bubble. LinkedIn is a profitable company. It can stay in business even if its stock price plummets. But dealing with a big stock-price decline, and with the expectations built into an unrealistically high stock price, can be extremely painful. Finance scholar Michael Jensen has argued that overvalued equity was the ruination of Enron and Worldcom, among other companies. But what's a CEO to do about it? I invited Jensen to a Fortune conference a few years back and watched him argue to a roomful of executives that if their companies' stock was was overvalued they should do what they could to bring the price down—by announcing to investors that they thought it was too high, for example. It's fair to say that they all thought Jensen was crazy. A less drastic approach is simply to insulate your company somewhat from financial markets: Don't let stock options account for a very big share of executive pay, focus the company on real performance metrics and not on stock price, build your business around the "real market" of customers rather than the "expectations market" of investors (I stole that terminology from Roger Martin's new Fixing the Game). None of which is going to seem very enticing when your company is caught up in a stock price bubble.