The boom and bust of tech innovation

The bursting of a great economic bubble was the herald of the 2008’s great recession, and some economic analysts predict that the American economy is set to fall into another one of these bubbles in the near future, if we’re not in one already. To understand the concept of economic bubbles and crashes, and to give a more optimistic perspective, we spoke with Dr. Brent Goldfarb and David Kirsch, professors at the Robert H. Smith School of Business and co-authors of the recent book Bubbles and Crashes: the boom and bust of technological innovation.

ABERMAN: Well, I think that you’ve written a very important book, it’s very topical. And I want to talk about bubbles and crashes, because frankly, I think that a lot of us in the innovation community are really interested in things like technological cycles. Where are we? Is there another one coming? What happens when an economy blows up? There’s so many questions, and I find these days, when I talk with people about innovation, there’s a little bit of a sense of whistling in the graveyard that I get from a lot of folks. You know, are we in a bubble? What does this mean, what’s the next big thing? And you’ve just spent a good chunk of time really delving into it. So, this is a timely time for us to get together and talk about this. Brent, I’ll start with you, if you don’t mind.

GOLDFARB: Sure.

ABERMAN: Bubbles mean many things to different people. You drilled down, you and David. What does a bubble mean, from the standpoint of really having done the research?

GOLDFARB: A bubble is a rise and fall in a price of an asset, or a technology, or a stock, that isn’t justified by reason. So, in some sense, if you’re an investor, what you really care about is just the movement of the stock up and down, because why it happened, you can still lose money or make money either way. It becomes particularly interesting when that bubble, or the stock goes up, but the reasoning behind why that happened, and the reason people invested, was kind of dumb

ABERMAN: Is it a retrospective thing, David? So for example, as you mentioned the book, the rise of RCA, going up through the Great Depression, and then the bubble burst and the not recovering value for 30 years. Is it a retrospective thing, or are there certain aspects, or are there other characteristics to it?

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KIRSCH: To identify a bubble, you need to look, and in the book, we develop a model that looks over a seven year running window. We do look backwards, and say, well, what happened, and we use hindsight. In practice of course, for investors, you don’t know what’s going to happen in the future. And there were several cases where we would have expected a bubble, but in fact the technology or the industry sort of bailed out those early investors. So, things like television, which was a pretty crazy thing. Wow. They’re moving people on a screen. And it had many of the aspects that we associate with the causes of bubbles. But it turned out, and it did go up.

I think we forget exactly the number, I think it went up two standard deviations, but it didn’t go down. You know, there was like a little window, but in the end, television kind of worked. Now we could contrast that with radio, which really didn’t work. Investors in RCA in 1929, who bought the stock in 1929, didn’t recover until the 1950s. But I think what ends up happening, in the case of television, is people sort of learn from radio, and the business model, a lot of the stories going on around television, I think people are able to understand, because they’re in some way similar. It’s visual radio. So, that ends up not being a bubble. But I think there is, to go back to your general question, we are looking at both the rise and the fall. For us, it’s not a bubble if it doesn’t pop.

ABERMAN: Well, yes, a fair comment.

GOLDFARB: Well one of things that’s kind of interesting, it’s actually something we describe a little bit in the book, about this investor in 1922. And she’d gone to a department store, and she had heard the radio. And you can imagine, 1922, this is really interesting, that you can transmit voice in this way. And so, that was super exciting. So, she wrote into the editor of The New York Tribune, as it happens, and she wrote it like this, I’m paraphrasing, but: this is such a cool thing, this is a great idea. Give me the name of a stock that you know will make money.

And so, she is obviously naive in terms of investing, but perhaps more than that, she understood quickly that radio would be useful. And I think that we here in this radio studio can attest to the idea that radio is a useful thing. But at that time, it was simply a novel how to make money. And moreover, she presumed that whoever, that part of the market that would make money, were those who were producing radio sets. And it turns out, completely wrong.

ABERMAN: It was the broadcasters, those who created content. It was the same issues, you pointed out, and other people have pointed out, in the electric industry. You know, a lot of it really is that, an industry or technology comes about, and people aren’t quite sure what the business model is. Let’s talk about it from the standpoint of a bubble. So, you look at it, you can identify it.

It’s not lasting value creation. It pops. You’ve identified certain characteristics that bubbles have, and this is what triggered me, you mentioned the the woman saying all this is really cool. It seems like a pattern in a lot of these bubbles is an unsophisticated, or new entrant, into a market, getting excited and saying just, I don’t care what it is, I just want to buy it. Is that one of the indications of a bubble?

KIRSCH: One of the features or elements of the model in the book, and one of the things that we we pay a lot of attention to, is the presence of what we call novice investors. So, if there are novice investors in the market, and you could think of this as sort of excess liquidity, if that’s sort of how the finance people would talk about it. But it, more particularly, if there are people who are sort of susceptible to a good story, that is a danger sign, and those can be individual investors like Brent was talking about in the case of 1922 in radio, or it could be, we identified a whole group of first time angel investors in Silicon Valley.

These were Facebook and Google millionaires who just happened to have been in the right place at the right time, and were then making, all of them, 4500 of them, were making their first angel investment Those are novice investors, those people are probably unsophisticated, and don’t know what they’re doing when it comes to private equity. They may have been very good coders, or have been in the right place at the right time.

ABERMAN: And by the same token, it doesn’t necessarily have to be a technology related thing. I think for example of the mortgage banking crisis, and the idea that the collateralized mortgages, which frankly, having been a trader, I can tell you nobody really understood. But it didn’t matter, because they were triple-A rated, and people just bought yield and were uninformed.

GOLDFARB: It’s even worse than that. It’s not only that that those who are creating them may not have understood, and there may have been fraud, but think about who is buying that. And that’s, without some group or some money that was eyeing these mortgage backed securities, there wouldn’t have been a bubble, because it wouldn’t have been fueled, because it would have stopped at the banks. And so, I think those were the novices of that particular bubble, alongside the new homebuyers which were moreso.

ABERMAN: So clearly then, your research has shown, and I think this comports with my worldview, that when you have people who get over-excited about a narrative, and don’t really understand what’s going on, it’s much more susceptible to an increased, or a ridiculously increased, evaluation. What are some of the other indications that you think we can look at to say, well, we’re in a dangerous place?

GOLDFARB: Well you’ve kind of hit on two of them, which is the novices and the narratives, and I’d like to come back to the narratives, but first, there’s two other things that are kind of important. Actually one’s really important which is, in many new technologies, it’s not possible to directly invest in a company that is commercializing that technology. For example if we for a moment think about the modern day, if you will, in electric vehicles. If not for a Tesla, then you would not have a way to invest directly in the electric vehicle.

KIRSCH: Maybe NIO now, but not until recently. I suppose maybe you could get into some Chinese markets, but it’s very hard.

ABERMAN: So artificial intelligence, for example, if you’re going to do a big play in A.I., do you buy Google, or you buy Amazon or Facebook?

GOLDFARB: The other thing is, there’s usually a lot of uncertainty about the future value of the technology. You’re probably not going to get a bubble in Subway franchises. It seems pretty unlikely.

KIRSCH: Yeah, the range of outcomes of a Subway franchise are pretty narrow. It’s going to be pretty good or pretty bad.

ABERMAN: So, it’s a narrative and an opportunity that that parses towards a high growth scenario. And so, there is an element with all these things that it has to at least pass some sort of smell test, whether it’s third world lending because countries never go bankrupt, or subprime, or electric cars, it has to pass the smell test, right?

KIRSCH: Well, I think that’s where the narrative is. We’ve talked about the idea of technologies having a sort of different levels of narratability, that’s a kind of a crazy word. I mean, we haven’t really used it yet around this space. Narratability. But the idea of narratability is that certain technologies more avail themselves of narratives, and other technologies, you can’t spin that many stories about them. So if there’s no narrative to attach to the technology, then it’s unlikely to generate the bubble behavior, because you can’t get excited about it.

GOLDFARB: Bubbles come when you’ve got a good story to tie together some very uncertain ideas about the world. And you have to have that narrative to put together, and it’s a lot easier to tell a story about human flight than it is about new steel making technology, because nobody really cares unless you’re in the steel industry. But it’s not that interesting to talk about steel making technologies, I’ve bored some dates about that. On the other hand, if you’re in a world where there are no jet planes, and flight is this new thing, the idea of being able to go from New York to Chicago in five hours as opposed to 20? That’s a big deal.

ABERMAN: It seems that particularly these days, we’ve gotten so efficient at telling stories on social media, the Internet, and so forth, that there’s an awful lot of temptation on the part of companies now to shift the narrative and almost create bubbles. You know, a Lyft or an Uber for example.

GOLDFARB: Oh yeah, without question. It was actually kind of shocking what David pointed out to me earlier this week, a nice article about Lyft in its upcoming IPO. So, we don’t know exactly when it’s going to happen, presumably in the second quarter sometime. But one of the things they did was, they were discounting rides to raise their market share, so that they could take that market share onto the road show. But that doesn’t tell us anything about the underlying viability of the business. That just means that they’re willing to lose more money to tell a good story and create and weave a nice narrative around ride sharing. That is a perfect ingredient for a bubble. And that’s kind of what we describe in the book. If I were an investor and I’m watching this being reported, I would not fall for that.

ABERMAN: Well you raise an interesting point, which is that, so, some companies that buy market share, think of Amazon for example: I mean for years, they were buying market share and subsidizing their costs in order to get a monopoly position, which they achieved. You know, you could understand that strategy. A sophisticated investor could look through and say, all right, that makes sense to me. And again it seems to come back to, we were talking in about the first segment is that a bubble, by its nature, people get excited and they don’t ask the hard questions.

KIRSCH: I think that’s right. Part of it is, when things are uncertain and there is still a lot of uncertainty, it’s easier to discount expertise, or to kind of put forward competing narratives, or competing explanations. When a company like Lyft goes out and says, we’re going to do all these things, we’re going to leverage our base of customers, and we’re going to grow in all these markets, and they tell a story about the future and describe that in rosy terms. We don’t know that it’s not true. And because it is a relatively new industry and there is legitimate uncertainty about what will happen. So, part of what makes technology interesting and exciting to study, and potentially exciting to invest in, is that uncertainty, is the upside. What might happen? But in a lot of cases, we don’t hear about the failures, the downside, the things that could go wrong.

ABERMAN: No, no entrepreneur I’ve ever met with when they’re looking for investment dollars from me tells me about how they fail. But of course, I can say that I’ve never invested in somebody unless I understood how they dealt with failure, because you learn a lot more from somebody about how they’re going to perform. I think the same is true for companies. Is that what you’re getting at? We need to get past the the hype?

KIRSCH: Well certainly, but we were thinking about it also in the context of how companies should be required to be forthright about the kinds of risks that they’re facing. So if you know when you open that prospectus, the Lyft prospectus, whenever that happens to drop, you’ll be looking at something where all the risk is written in boilerplate legalese. I’m sure you’ve drafted many of those things in your day. You know, this bad thing might happen, we cannot assure our future, there are an unknown risks to which we may be susceptible. There is lots of uncertainty.

But it’s this very kind of clinical legal boilerplate. But then the story about growth is, oh, look all the cool things that are going to happen, and there, the story is told in a connected way, with actual people doing actual things, and pictures of people’s lives made better. So you know in a way, our thought was, well, maybe we should ask the FCC to require of the companies seeking public funding that they tell the the downside stories with the same protagonists, and the same sort of narrative structure that they tell, that they use to talk about the upsides.

ABERMAN: I’ll tell you, when I was a securities lawyer, which you alluded to, my biggest challenge was keeping entrepreneurs out of trouble. And I did have one who, we were going public, and he had all these great things he wanted to tell people, and I had to say, no, you don’t understand. The more you tell people they can lose money the better it is for you. So finally, he lost his temper and yelled at me, and said, why don’t you just tell everybody that the sun could stop burning? I said that’s a good idea, I’ll add that, and he walked out of the room. I won that moment. But the issue ultimately is that, we seem to be operating in, particularly in the tech economy, in a bubble.

A bubble of excitement from the standpoint of, you know, you talk with an entrepreneur, we work with them in the Smith School and elsewhere, how are you doing? I’m killing it! You know, the whole idea in entrepreneurship, tech entrepreneurship, is always optimistic, always optimistic. So David, you mentioned to me a bit earlier, Steven Pearlstein has written and said, we’re now basically in a bubble economy, where we’re addicted to bubbles. What do you think he meant by that, and how does that relate to what we’re talking about today?

KIRSCH: Well I think that you know we obviously had a very severe bubble in 2008, related to real estate. And for many people, those memories are still very fresh. But it feels like we don’t know what the first correction post-Great-Recession will look like. I think there is a lot of thinking, and I think this was Pearlstein’s point, that we could just be going bubble to bubble, that we sort of managed to dig our way out of that 2008 bubble, and we’re just going to go headlong into the next one, because that’s all we know how to do at this point.

GOLDFARB: So, obviously you can’t know if you’re in a bubble, by definition. You only know this ex post, but there are some things, there’s signs that we can look at, and we should look at, and we should teach people to look at very carefully. And one is, what is the narrative behind the market, or any stock, or any industry, at any given point in time? And if there is a good, or even a too good to be true story, that is appealing to a lot of people, and individuals who may not have a deep understanding of that stock or that market, then we should be worried. So for example, one of the questions I would always ask about a stock or an industry is: are the people investing the same people using the service?

Because if you’re using the service, or if you’re a customer, you may think, oh, I understand this, I’m driving a Tesla, this is a great car, and therefore a great investment, and therefore it’s a great company. But the business of making cars, and the business of driving cars, are different things. And the economics behind driving a car are hard. And so, that extra insight is something that’s necessary to make a smart investment, and it’s not always clear to us, as scholars and observers, that those making that investment are doing that extra legwork of thought.

ABERMAN: And what’s fascinating is that, even where you have a bunch of sophisticated people involved, like say Theranos, the diagnostic company in Silicon Valley, that’s a company bubble, but it turned out the billion dollars of evaluation were supported by nonexistent technology. This is a really hard thing to do. So are we going to have to just accept that, with the technological society where we have to keep pushing things to the edge to find new wealth creation, that a bubble is just inevitable? Or do you think that we can have our cake and eat it too?

GOLDFARB: Well in some sense, we will always be making bets. That’s just fundamental to capitalism and to entrepreneurship, that you’re going to make bets that are going to fail. Some of those bets are good bets. And we should be making those bets, and you know, investors and entrepreneurs will lose money because of that, and that’s fine. And there’s no way around that. That’s in the nature of the system. However, we also live as, you mention, in this hyper narrative, hyper media world, where ideas and narratives can catch on, and not be critically examined. And I don’t see any reason, and maybe David does, I don’t see any reason why we can’t learn to slow down a little bit, and make critical decisions, and be much more careful about where we put our money.

ABERMAN: What do you think, David?

KIRSCH: I think that’s a fair point. And you could think about… I guess I’m old enough to remember the idea of the Internet as friction-free capitalism. I don’t know if you remember that. So you know, maybe a little bit of friction is actually a good thing. Things that slow us down a little bit, slow down decision making, slow down stock trading. It’s very hard for me to see how always faster, always more information, is always better, or leading to better decisions about things, important things, like the future of technology.

GOLDFARB: And the reason is that we make decisions based on stories and narratives, and we can’t do that instantly, or at least we can’t do that instantly in a critical way.

ABERMAN: So as we come to the end of our time together, it strikes me that what you’ve identified are certain characteristics of what makes a bubble: a compelling narrative, maybe something that is not easily understood by people, new investors coming into the marketplace. And it all comes together, and creates a lot of velocity, and a change that may not be supportable. So if I’m listening to this, and I’m a sophisticated investor, a thoughtful investor, these are things I can see. So in some ways, it appears to me like you’ve actually given people who are sophisticated investors, or people who are worrying about the next bubble, you’ve given them some tools here.

GOLDFARB: Yeah. In fact, we have in our book a list of questions that any investors should be asking about a new investment, if they think that they’re in in a bubble. And they’re pretty specific, there must be 20 questions there about, you know, the level of uncertainty, the narratability of the technology, and more.

ABERMAN: So there you have it. We’ve actually come to the end of our time together, and we’ve provided a compelling reason why people listening should go off and buy Bubbles and Crashes, written by our guests, Professor Brent Goldfarb and Professor David Kirsch from the Robert H Smith School of Business. Brent, thanks a lot for joining us today.

GOLDFARB: Thank you for having me.

ABERMAN: David, it’s great to see you too. Thanks for coming.

KIRSCH: Likewise. Great to be here.

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