The Dotcom crash didn’t pop like someone bursting a balloon. Instead, it deflated over a year, like someone had untied the balloon and was slowing letting air out, making a farting sound. Between 2000 and 2001, the Nasdaq lost over 75% of its value. Hundreds of companies went bust, and millions of Americans lost money.
Some people are using the “b-word” to describe our current economic climate. Others are comparing our current tech investing frenzy to the dotcom bubble of 2000. But is the current bull market actually comparable to the dotcom bubble? We need to take a closer look at what caused the bubble in the first place, as well as what caused the bubble to burst. Then we will be able to take look at what the current market looks like, to make an informed decision whether or not we are indeed experiencing a bubble.
The Dotcom Bubble
Between 1995 and 2000, the value of the Nasdaq, a stock exchange known for tech stocks, increased by over 400%. In the final five years of the 20th century, hundreds of companies went public on the promise of capitalizing on a very special new invention: the internet.
This rise in investment was fuelled by two things. First, investment banks encouraged their clients to invest in technology. This was so that the banks could make money when the stocks popped on the first day of trading. Second, individuals quit their day jobs to trade the financial markets. By the end of the bubble’s formation, it was individuals holding the tattered remains of these companies.
Given the ubiquity of the internet now, it is hard to imagine a company that was special or different because it was based on the internet. At the time, companies that were based on the internet were revolutionary. The issue was that the companies’ managers hadn’t yet figured out how to run an internet company sustainably. The popular conception was that the companies would be able to take advantage of the scale that the internet offered, optimising for “mindshare” in the short run. These companies might not be profitable now but might “one day” become hugely profitable. Some companies even IPOed before they had a product in the market, hoping to take advantage of the investment mania.
The issue, or one of the issues, with the way the companies tried to do this, was that it involved unsustainable advertising spending. One company that embodies the dotcom bubble is Pets.com. Pets.com went bankrupt 9 months after their IPO, after spending $25 mil USD on advertising. Overall, internet companies spent $40 million on advertising at the 1999 Super Bowl, buying over 40% of the available advertising inventory.
The other reason that the bubble popped is because there weren’t enough internet users. In 2000 there were only 400 million people online in the entire world. The advertising spending that the companies were doing might have worked if there were more users, but “gaining eyeballs” and being “top of mind” doesn’t matter if most of the people who see the advertising aren’t on the internet. It’s like advertising cat food to dogs.
Why did it Burst?
The Dotcom bubble deflated over more than a year, starting in February 2000 when Alan Greenspan, Chair of the Federal Reserve, decided to increase interest rates. The cost of borrowing money increased, which meant it became even less sustainable for dotcom companies to run without profit.
Around this time Wall Street Banks, the same banks that advised their clients get into tech, started to advise their clients to get out of tech, calling dotcom stocks “no longer under-priced”. In March Japan entered a recession, Yahoo and eBay failed to merge, and Barron’s, a newspaper published by Dow Jones and Company, led with a cover article titled “Burning Up; Warning: Internet companies are running out of cash—fast”. Oh, and the Fed increased interest rates again.
By April, the decline of the Nasdaq was truly in progress, but the final two nails in the coffin were yet to come. First, Microsoft was found guilty of anti-competitive practices, which most people saw as a bad sign for technology companies in general. Second was Tax Day, which in the US falls on the 14th of April every year. On this day, many people had to sell their shares to be able to afford the capital gains tax on the increase in value over last year. On April 14th, the Nasdaq fell 9%, ending the week that it dropped 25%.
The falling value of tech stocks meant that tech companies were left without investors, burning through remaining money. Only 48% of dotcom companies survived this downturn, the rest were liquidated. By the end of the downturn in 2002, more than $5trillion in value had disappeared.
Are we seeing a bubble today?
With this retelling of the dotcom bubble, it seems that we are indeed seeing a repeat of 2000. Investing is more accessible than ever due to applications like RobinHood or eToro, and consumer investing is driving the stocks of popular, “cool” companies like Tesla through the roof. Additionally, tech IPOs like AirBnb, Snowflake, Palantir, and DoorDash are seeing huge first day pops. Petco IPOed on Thursday to a 63% surge in price. (Sound familiar?) To top that off, Facebook is currently under investigation for antitrust practices.
But despite these external similarities, there is a big difference under the hood. Tech companies appear to be properly valued. The global aggregate earnings of the tech sector is three times higher than 2000, and prices are only 35% above the peak.
However, just because the stocks aren’t as overpriced as 2000 doesn’t mean we aren’t seeing a bubble. Internet software companies are trading at a 14.85 multiple (their market cap is 14.85 times above their revenue) while brokerage and investment banking, a much more stable line of business than internet software, is only trading at a 2.05 multiple.
One of the things that made dotcom companies so unsustainable was the advertising spend, something that hasn’t gone through the roof this time round. Managers now know how to run tech companies and create sustainable growth. This seems to be a point in favour of the “no-bubble” camp.
Another point in favour of no-bubble is that interest rates won’t rise any time soon. As there is currently a global recession with record unemployment around the world, the Fed will keep borrowing costs low to encourage spending and keep the economy moving.
Will we see a bubble tomorrow?
Interest rates are low now, and printers at banks around the world are working over-time to produce enough money to fund government programs. This should, in theory, be the prefect recipe for inflation. The one thing that is missing is demand. When that picks up in the future, due to vaccine rollouts and a return to higher consumer spending, we might see an increase in interest rates.
But this might not mean much. We currently don’t know if current investing in technology is realistic based on growth prospects or whether what we are seeing is irrational exuberance. That’s the thing about bubbles, they are famously hard to spot while you are in them, and obvious for all to see once they pop.
One measure to watch over the coming months will be whether company insiders think that their company’s is overvalued. How might we know that? We wait until the end of the lockup period and watch the prices carefully.
After an IPO, there is a period during which employees and owners are restricted from selling their shares. This period is called the lockup period. This stops the market from being flooded with shares which would drive the price down. The logical move, if you are an employee holding overvalued shares, is to sell the moment the lockup period ends, driving prices down.
Whether or not we are in a bubble is hard to know. But a sign to watch for will be whether or not company shares dip after the lockup period.
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Callum Macdonald 