Professional and consumer traders are always looking for the next big thing in the stock market. They salivate over the next Facebook, clamor for another Amazon, and yearn for a second chance at a Netflix stock. It was March 2017 when investors thought they had it. Snap, the owner of social media app Snapchat, closed its first day of trading up 44% from its initial public offering (IPO), leading the bulls to declare that this is the motherlode – bears just shrugged. Today, Snap is trading at around $8 – again, bears shrugged.
Fast forward to the present, and the running of the bulls has commenced again on Wall Street. This time, it’s SVMK Inc., the parent company of survey-software maker Survey Monkey. The dot-com-era company recently filed an IPO after selling 15 million shares at a price of $12 with a market capitalization of $2 billion. The result? The stock soared 56% above the IPO price to $18.75 a share days later. It has since cooled down to around the $15 mark
What do these two companies have in common? They have yet to post a profitable year, and they’re not projected to have one for another several years – if at all.
Ocean of Red Ink
But this has been the bigger picture in the IPO market this year, says University of Florida finance professor Jay Ritter, who compiled data on companies going public in 2018.
According to Ritter, 83% of U.S. companies going public between January and September have lost money in the 12 months leading up to their IPO. The last time it was this high was in 2000, when 81% of the IPO market had money-losing firms.
For the young ones reading, the year 2000 was the height of the dot-com bubble.
Investors are having their gambles pay off – at least in the short term. These unprofitable companies recorded an average gain of 36% from their IPO price, compared to 32% gain among businesses with positive earnings. It’s quick cash in your pocket.
Over a longer period of time, the businesses swimming in a sea of red ink were unable to maintain the momentum. Ritter examined thousands of IPOs that occurred between 2001 and 2016 and discovered that money-losing companies experienced the same performance on the first day of trading as profitable ones: 13.8% to 14.2%, respectively.
As time went by, though, there has been an enormous gap. In the next three years, unprofitable businesses returned an average 12.6% and underperformed the market by 9.7%. Meanwhile, profitable companies returned an average 30.4% and overperformed the market by 7.9%.
The same trends were prevalent in the 1980s and the 1990s.
And this has been the norm for years. Since the market bottomed out nearly a decade ago, a significant percentage of IPO companies have been unprofitable. Overall, just 19% of tech companies that have gone public are reporting profits, up from 14% in 2000. The one difference? Back then, investors poured money into sock puppet websites. Today, venture capital (VC) funding is pouring into mobile applications that say “Yo!” to friends.
Despite the numbers, there is still a ferocious appetite for hot stocks, especially as the unicorns (pre-IPOs with a $1 billion valuation), like Uber, 23andMe, and Airbnb, sit on the sidelines.
The main problem is that investors are suffering from a mix of FOMO (fear of missing out) and a Federal Reserve-induced sugar high. With all the excitement surrounding the IPO market, traders do not want to forego the immediate gains, nor do they want to suffer from regret should the stock turn out to be Tesla, Alphabet, or Amazon in the next five to 10 years.
Crashing and Burning
Central banks have flooded global financial markets with cheap money – money-printing and historically low interest rates remain the one constant, despite the gradual normalization of monetary policy. In July 2017, world stock market capitalization topped $78 trillion, ballooning from $10 trillion in 1992.
Are the fundamentals sound or are these overvalued markets fueled by bubble economics?
We have witnessed bubbles pop up in several other asset classes, like classic art, housing, and vintage cars, over the years, and they are beginning to deflate as the freshly created money seeps into the rest of our wallets.
What makes us think this time around is any different?
From rising corporate debt levels to the gap between consumer confidence and savings, from the Fed’s supply growth remaining steady to rising junk bond valuations, there is a lot of evidence to suggest that the market is on the cusp of crashing and burning. While President Donald Trump’s superb tax cuts have prolonged the expansion, it is inevitable that the party will eventually come to an end. That said, as long as the Eccles Building keeps the printing presses on, and rates are parked below historic norms, the mirage can give us the illusion of sound fundamentals. It’s just too bad that Trump will take the blame rather than the rightful assailant: The Fed.
Do you think the stock market bubble will pop? Let us know in the comments section!