Investors are twitchy and for excellent reasons. As bitcoin's abrupt slide and tech stocks' surprise weakness this week demonstrated, it is awfully hard to put a rational price on some of today's most popular investments.
For instance, how do you even begin to value a commodity such as bitcoin? With no government support, no firm backing by physical assets and debatable practical utility, a cryptocurrency can flit up and down in perceived worth, driven by nothing more than gusts of investor sentiment. There is no logical reason for bitcoin to be worth $11,377 (U.S.) one day and $9,290 the next. But then anyone searching for logic in the cryptocurrency's gyrations over the past few months is looking in the wrong place.
Tech stocks are more easily valued because they have earnings or at least cash flow. But there, too, a diligent investor runs into problems. In theory, you can calculate the present value of a stock by discounting future dividends back to the present day at an interest rate that reflects the current cost of capital. However, with tech stocks, many of which have no or scant dividends, this exercise often degenerates into wishful thinking. How do you know how Amazon.com Inc. will be performing 10 years from now, and what level of dividends it will be paying? It's impossible.
All of these problems are exacerbated by low interest rates. If you attempt to discount future payments back to the present by using a rate that reflects today's near-zero real cost of capital, it's easy to arrive at stunning valuations. To put that another way, investors who expect to derive no after-inflation return from bonds may be willing to bid silly prices for any asset that holds a reasonable chance of delivering real returns in the years ahead.
To be sure, this week's weakening sentiment toward bitcoin and tech stocks reflects many factors, not just valuation concerns. Among other motivations, investors may be trying to position themselves for the potential passing of a tax-reform act in the United States. Tech stocks, which already pay relatively low taxes in part because of their ability to harbour money in other regions, are expected to benefit less than other areas of the U.S. economy, so there may be some sector rotation going on, as money moves into industries that are likely to derive a greater boost from the tax legislation.
But that can't be the whole story, because European and Asian tech stocks were also caught up in the sell-off on Wednesday. One possibility is that investors are growing more confident about prospects for global growth. If so, the case for owning tech stocks weakens, because the sector will no longer be the only area of the economy with strongly expanding profits.
Yet another factor may simply be the impending year end. Investors who have done extremely well by holding tech stocks and bitcoin this year may be trying to lock in profits by selling. A desire to cash in on big winners and shelter in more stable holdings may also be behind this week's decline in Chinese stocks and surge in the blue-chip Dow Jones industrial average.
Of course, none of these reasons for selling has anything to do with fundamentals. On Thursday, there was a modest bounce back in the tech sector as some investors decided the earlier decline amounted to a buying opportunity.
But it's reasonable to expect more volatility ahead. Tech stocks, as well as stocks in general, will face a headwind in coming months from rising U.S. interest rates as well as a general decline in global liquidity, as central banks begin to ease off some of their more exuberant crisis-era interventions.
For their part, bitcoin and its cybercousins are just beginning to face increased scrutiny by regulators, who are concerned about the proliferation of cryptocurrency launches as well as the potential for tax evasion.
The U.S. Internal Revenue Service won a court order on Wednesday that will force Coinbase Inc., a San Francisco-based digital currency exchange, to hand over identifying information on its larger accounts. The IRS is concerned some cryptocurrency speculators may not be reporting their bitcoin profits and paying the appropriate tax. Imagine that.