Innovation and Stock Market Bubbles
Our economy benefits from the innovations funded by irrational exuberance.
By: Brian Chingono
Every few decades, a new groundbreaking technology captures the world’s imagination and fuels a stock market frenzy: railroads in the 19th century, automobiles in the early 20th century, the internet in the 1990s—and today, artificial intelligence.
It is often assumed that the stock market bubbles associated with these innovations are irrational—an upward spiral of exuberant investor expectations that become unmoored from reality. Yet a research paper (Sorescu et al., 2018) that examines two centuries of landmark innovations adds nuance to this common assumption. Based on evidence from 51 major innovations from 1825 to 2000, the authors argue that bubbles are a necessary component of innovation because they provide a window for innovators to raise cheap equity capital, enabling them to commercialize their products and drive growth for their firms. Of course, the cheap equity capital doesn’t always earn high returns, often funding duds and also-rans in addition to innovative firms, but we believe no true progress happens without trial and error.
While former Federal Reserve Chairman Alan Greenspan is well known for coining the term “irrational exuberance,” he also acknowledged that bubbles help to fuel the diffusion of innovations by providing the financing needed for their widespread commercialization. Without a bubble, a major innovation may never take off or reach its full potential. This is illustrated by Greenspan’s observation that “there were no bubbles in the Soviet Union,” which lost the space race and fell decades behind the West in terms of technological and economic development.
Importantly, the authors of the study define bubbles at an individual product level, rather than a market-wide level. This allows for the evaluation of bubbles in the stock prices of innovative companies even during periods when the aggregate stock market was in the doldrums, such as the 1930s and the 1970s.
Firms and Innovations Included in the Dataset
For every major innovation between 1825 and 2000, Sorescu et al. match the product with publicly listed firms that commercialized the innovation. There are 51 major innovations over this time period, and a subset of these products and their parent firms are shown in the figure below.
Figure 1: Illustrative Subset of Innovations and Parent Firms (1825 – 2000)
Source: Sorescu et al. (2018)
Notably, these innovations span multiple industries and macroeconomic environments. Among the 51 major innovations, Sorescu et al. found that the commercialization of these products was associated with bubbles for their parent firms in 73% of cases.
Defining Bubbles
The authors define bubbles as cases where an innovator’s stock price trades at a statistically significant premium to the present value of its future cash flows. Future cash flows are estimated from forward dividends and forward stock prices. These future cash flows are discounted to the present to estimate each innovator’s fundamental value. A bubble is identified whenever an innovator’s actual stock price exceeds this estimated fundamental value for more than five consecutive months within a rolling two-year period.
It is clear from this methodology that bubbles can only be identified with the benefit of hindsight. That is because fundamental value can only be estimated with perfect foresight into future dividends and stock prices. This makes it almost impossible to accurately identify the peak of a bubble in real time because doing so would require knowledge of future cash flows.
Empirical Results
The main finding of the study is that 37 out of the 51 major innovations (73%) were associated with statistically significant bubbles for their parent firms after the innovations were commercialized. This seems to suggest a close link between groundbreaking innovation and bubbles for the parent firms who commercialize these products.
The stock price bubbles were larger in magnitude for innovations that were:
Highly radical: New technologies that were substantially different from existing products at the time resulted in bigger price appreciation for their parent firms. Examples of highly radical innovations would include the telegraph, electric refrigerator, airplanes, television, the internet, and smartphones.
Conducive to network effects: Innovations whose societal benefits increase with the number of users also saw higher price appreciation for their parent firms. An example would include the steam engine train, whose value increased with the size and geographic reach of the railway network.
Publicly visible: Innovations that were more frequently mentioned in books and newspapers around the time of their commercialization—as recorded in Google’s historical database of digitalized books—saw greater price appreciation for their parent firms.
Implications for Investors
Bubbles are commonly perceived as market-wide mispricing events, but Sorescu et al.’s research shows that product-specific bubbles only translate to market-wide bubbles around 50% of the time. So the odds of an individual innovation being associated with a market-wide bubble are similar to a coin flip.
For investors, it may be more informative to consider the implication of bubbles at the level of individual innovations. This “bottom-up” approach, focused on parent firms, yields the following insights, according to the study:
Equity financing: Innovative parent firms typically raise new equity capital during bubble periods for their stock. The amount of equity capital they raise is usually proportional to the magnitude of the bubble. Across all innovations that resulted in bubbles, parent firms were able to raise equity financing that amounted to 18.6% of their starting market capitalization from the beginning to the end of the bubble.
Economic value: From the beginning to the end of innovation bubbles, total returns for parent firms exceeded market returns by 44.6 percentage points. This suggests that investors who held innovative firms at the beginning of a bubble and somehow knew to exit their positions at the right time would have captured the economic benefits generated by groundbreaking innovations. It’s important to note that this excess return does not fully capture the long-term reversals that typically follow the end of bubbles because the authors’ bubble test only requires two consecutive months of a null result to declare the end of a bubble.
Product diffusion: Parent firms that raised more equity capital saw faster and broader adoption of their innovations, as indicated by the frequency in which their products were mentioned in printed publications of the time. This suggests that bubbles can accelerate the build-out of new technologies and infrastructure.
Conclusion
As with the expansion of any infrastructure, the rollout of groundbreaking innovations is financed by “taxes.” In the case of building out innovations, it’s informative to consider who pays the tax to accelerate the adoption of new technologies. Excess returns relative to the market are zero sum. To the extent some investors outperform the market over a period of time, it’s because another group of investors are underperforming by the same amount. Based on Sorescu et al.’s research, it appears the “innovation tax” is spread among two main groups: (i) investors who are under-allocated to innovative parent firms during a bubble, when these firms generate positive excess returns, and (ii) investors who remain over-allocated to innovative parent firms after the bubble has ended and suffer the effects of long-term reversals. Because bubbles can only be identified in hindsight, it is generally impossible to tell which group of taxpayers you are in at a given point in real time. As with levies paid to the government, the “innovation tax” seems to be unavoidable, but may hopefully result in societal benefits someday.