The market buzz of the past few years has been largely centered on futuristic companies with groundbreaking technologies that will “change the world.” We’re talking breakthroughs such as genomic sequencing, blockchain and metaverse infrastructure. Post-pandemic, these stocks went on a historic run and, alongside them, actively managed ETFs owning such stocks rode the wave higher.
But now some of those ETFs are down almost 50% from their highs. News like that naturally leads to two questions:
- Why did this happen?
- And does this crash present any opportunities for investors brave enough to capitalize on them?
First, Why Stock Bubbles Form
Most companies in this buzz-filled category share one thing in common – they are unprofitable. Why would anyone want to own a company that loses money every year? Well, because at some point in the future, there is a possibility that they will be wildly profitable. But it is incredibly hard to assign a value to a possibility and thus, when bubbles form, it is typically in stocks such as these. The “dot.com” bubble of the late '90s and early 2000s is a larger analog.
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Why is this category more bubble prone? Because there is little burden of proof when making predictions of potential. It is much easier for a charlatan-esque ETF manager to make claims that will not be validated for another 20 years or more. They may be gone from the industry by then. The valuation of a boring consumer staple company with a track record of increasing profits and cash flows is more accurate, because the concept has already been proven. Thus, paper towel makers typically don’t get bid to nose-bleed valuations – and managers who own them don’t get famous.
What to Consider Going Forward
Over the past year, the most noteworthy “innovation” ETF crashed nearly 60% from its high to its low. Other tech innovators have also struggled. So, this most recent bubble has burst, what now?
There is rubble everywhere, in the form of innovative tech stocks way off their highs. Should you pick through them? Twenty years ago, some of our current megacap tech stocks were in that rubble and have surged thousands of percent since then. It is possible there are a few gems in this current rubble, the question is, can you find them? If you try, be sure to do your research because what may appear to be a “cheap stock” can always get cheaper, and some of these recent casualties may not be around in the future.
Alternatively, you could let the pros do it for you and buy one of the aforementioned ETFs that owns all of the rubble. The managers claim that each of their holdings will someday be highly successful but, in reality, whether they know it or not, they’re using something similar to the venture capital playbook – meaning that most of their ideas won’t pan out. In fact, only 8% of VC startups are successful, according to the Corporate Finance Institute. These VC investors rely on the few hot companies that do succeed to drive the returns, and the same will probably be the case for these ETFs.
If you plan to dip your toe in this category, do so with that understanding and have realistic expectations. Many investors burned by that 60% drop also watched that same ETF rally 380% post pandemic and might have thought, “This time it's different – these stocks really will grow to the sky.” But in the stock market, it is rarely different.
* Securities and advisory services offered through LPL Financial, a registered investment adviser. Member FINRA/SIPC.
* Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All investing involves risk including loss of principal. No strategy assures success or protects against loss. ETFs trade like stocks, are subject to investment risk, fluctuate in market value, and may trade at prices above or below the ETF's net asset value (NAV). Upon redemption, the value of fund shares may be worth more or less than their original cost. ETFs carry additional risks such as not being diversified, possible trading halts, and index tracking errors. ETFs concentrating in specific industries are subject to higher risks and volatility than those that invest more broadly.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. Securities and advisory services offered through LPL Financial, a registered investment adviser. Member FINRA/SIPC.
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