From tulips to artificial intelligence

For a year now, there has been nothing but talk about artificial intelligence. Not unjustly probably, given the scope of the implicit and profound potential changes in many areas of our existence, social, economic and cultural.

We will leave the sociological assessment of the phenomenon to others (more knowledgeable than us in this), concentrating rather on the levels of euphoria generated on the markets and on how, once again, the thrill of the new phenomenon of the moment has disrupted the decision-making and evaluative processes at the basis of sound and correct portfolio management or, in the worst case scenario, of one's savings.

The funny thing about this story we are about to tell you is that this is not the first time it has happened! The precedents are numerous and painful, yet they repeat themselves with unceasing regularity and sinister similarity over time (perhaps we could say centuries).

When the ‘price doesn't matter’ because the prospects are unparalleled, you are sure to be on the eve of something unpleasant, a rude awakening from a fabulous drunkenness with all the annoying after-effects.

Price, in truth, always matters, primarily because it is a unit of measurement of an exchange process. What I get in return is called value.

Secondly, because price is not an absolute measure, but relative precisely to the value I get in exchange.

In reality price and value are often, not to say almost always, misaligned even if a slight difference is physiological. When the price is significantly lower than the value we have a ‘bargain’, conversely when the price is significantly higher than the value we have a ‘bad bargain’. Sic et simpliciter.

In theory, therefore, there are few doubts and many certainties in the facts and over the centuries, but nothing goes as it should and bubbles follow one another with incessant regularity.

Let us begin the history of speculative bubbles in Holland in the 17th century. The Dutch Golden Age, the setting of the first and fully documented financial bubble in economic history, the tulip bubble.

The Dutch economy and society, or to be more precise the Dutch republic, was quite prosperous at that time. Trade, the natural anthropological inclination of the country, was fuelled by the company of the Dutch Indies, the first examples of state bonded estates were born, and in the arts, Flemish painters amazed Europe. In short, a flourishing period of great ferment, the Netherlands was going through its renaissance. The bulb trade was quite an important business and at that time the price of tulip bulbs was rising rapidly. Auctions were literally stormed by merchants from all over Europe with the price of the bulb reaching the astronomical figure for the time of 100,000 florins (the average income at the time was about 150 florins!).

In the end, the speculative bubble that had been created in the euphoria of nowhere exploded due to an unfortunate auction and the subsequent panic that ensued. The market collapsed. Hundreds of Dutchmen, businessmen and noble dignitaries fell into ruin.

In retrospect, going to ruin for a tulip bulb seems rather mocking and irrational, in short, foolish. With a little more salt in the noggin, we might say, the trap would have been avoided. Of course!

In the next century, it was the turn of the English and an exceptional protagonist, Sir Isaac Newton. Yes, he had a lot of salt in his noggin.

The object of the speculative bubble was this time the South Sea Company, a joint-stock company with mixed public and private capital, whose shares, boosted by rumours of miraculous deals with the New World, rose from 128 pounds to 1,050 pounds in a short time. Our own Isaac Newton realised the situation and sold his shares in the initial phase of their ascent, making a decent profit (about £7,000), saying, at least according to the chronicles of the time, ‘I am capable of calculating the motions of celestial bodies, but not the folly of people’. Too bad that, later, with the stock close to its highs he bought it back and when in 1720 the bubble burst and the price returned to £200 he had to reckon with a loss of no less than £20,000!

He almost made it but ironically, not even one of the smartest men in the world was able to resist this tangible lesson in gravity. Because as Warren Buffett says, it is not the high IQ that is needed to invest but temperament, i.e. the right orientation and reasoning over the long term without getting caught up in emotionalism.

Let us now take a leap forward in history. It is the 1960s at the height of the ‘Nifty Fifty’ stock mania, i.e. the stocks of the highest quality and fastest growing American companies. The belief that for a certain asset, ‘there can be no price too high’ found its apogee here.

The Nifty Fifty benefited from the new trend in vogue at the time to share in the rising profits of the companies most exposed to advances in technology, marketing and management. By 1968, the best and fastest-growing companies had appreciated so much that the banks' analysis departments had practically lost interest in all other stocks. It is very important to point out the loss of investor interest as a sign of a bubble and how this loss of interest always tends to repeat itself over time. For all intents and purposes, it is like narrowing one's field of vision, at that time limited to a handful of stocks: Xerox, IBM, Kodak, Hawlett Packard, Texas Instrument, Coca Cola and Avon.

Companies that were so solid that nothing bad could happen to them and it was a common idea that it did not matter what the price was. If it was a little too high, no harm done, the companies' profits would still grow, compensating for the expense incurred.

You may have already imagined the result. When people are willing to invest regardless of the price, it is obvious that they do so on the basis of emotions and popularity rather than conducting a cold-blooded analysis.

Thus the Nifty Fifty stocks that had been sold at 80-90 times earnings in 1968, at the height of a powerful bull market, collapsed (literally) to the ground as soon as enthusiasm cooled. The end of the bubble burst in 1973 saw losses of 80%. Many of those companies thought to be eternal are now bankrupt or have gone through serious internal crises.

Another lesson had been taught: no asset or company is so good that it cannot become too expensive.

It was clear to everyone.

Wasn't it?

To find out, let us move back to the late 1990s. The internet revolution!

It's true, the Internet has changed the world, which today is unrecognisable compared to thirty years ago. ‘The Internet will change the world’ was the battle cry, followed as always and again by ’no price is too high for an e-commerce stock.’

But while Nifty-fifty stocks had been sold at inflated earnings multiples, this time internet-related stocks were not making any profits at all!

So valuations were made on turnover, when there was any.

Companies listing under the name ending with ‘.net’ went up 50% on the first day of listing! Again, analysts and investors were only interested in internet stocks, losing sight of all other companies. Suffice it to say that 3M in ‘98-99 with the Nasdaq registering +275%, had shown +26%, and then went up 35% in 2000-2002 with the Nasdaq registering -73%.

Mind you, as in the case of the Nifty Fifty, there was a kernel of truth necessary for a bubble to begin, the internet was indeed destined to change the world but investors, once again had determined that price was not important by abandoning the moorings of reason and discipline with all the consequences.

Reviewing past lessons had been painful but, apparently, necessary and now it was really clear to everyone, wasn't it?

No, because at the end of 2007, just a few years after the euphoria of the internet, came the real estate enthusiasm. This euphoria this time, however, hit the heart of the investor, namely the house.

Again, positive expectations fuelled greed, leading to imbalances. These imbalances driven and supported by rising house prices led to the 2008 crisis. Houses bought at any price with a mortgage were now worth a fraction of the original cost when the bubble burst, but the debt incurred remained as it was.

A crisis that hit investor confidence and taught Central Banks a lot, especially how to react quickly (see the FED's strong and fast reaction in the 2020 pandemic).

Yet another lesson, repetita iuvant.

Or is it?

We are now in 2021 and the investor was fascinated by the technological revolution and blockchain. If we take one of the most successful products, namely Ark Innovation, an ETF that invests in the digital frontier and blockchain, its performance kept going up and no one questioned whether there might be too high a price for some companies.

Considering for example the top 15 stocks at the end of 2021, we coldly note that none of the 15 to date have shown a positive performance and the average has been -55%. So several companies that were thought to revolutionise the world are now in sharp correction and some have even gone bankrupt.

This historical overview is anecdotal, not exhaustive, but certainly significant in finding a key to interpreting the contemporary.

Today, the most abused and sought-after word is ‘Artificial Intelligence’.

A few days ago, Oracle's CEO mentioned the word AI several times during the quarterly earnings season, and the stock opened the following day up 10%. No one questions the technological revolution taking place and its effects in the real economy, but doubts arise about the timing, the valuations, and who will be the protagonist of the change! By its very nature, technology is destructive.

The bull market is born in negativity, develops in scepticism, grows in optimism and dies in euphoria.

At this time in the ‘psychology’ cycle, one should not get caught up in greed, but continue to invest in quality bonds and defensive stocks at a steep discount, two asset classes with returns that were unimaginable just a few years ago.

There is, therefore, no safe way to participate in a bubble: there is always only danger, as overpricing does not automatically lead to an immediate descent.

Bubbles are a natural result of markets and often last for a long time. People act on the markets who by definition are guided by emotions and feelings down tunnels where irrationality and price unpredictability reign, at the end of which, however, the light of reason always arrives and with it the lucid clarity of the relationship between price and value.

There is therefore only one form of intelligent investment: to determine value as best we can and invest at that price or a lower one, any other strategy would deliver us into the hands of statistical randomness of results and above all to the wrong side of history.