The dot-com bubble!

This week I was pretty free, so thought of studying about the dot com bubble that happened in the starting of this century. I feel it is always good to look back and learn what went wrong and learn for the future. I just like to jolt things down in the process and share the facts and my thoughts for any reference by anybody, only if I am able to give a new perspective to the whole situation.

The dot-com bubble(also referred to as the Internet bubble) was a historic speculative bubble covering roughly 1995–2000 during which stock markets in industrialized nations saw their equity value rise rapidly from growth in the Internet sector and related fields.

Now before we go forward, we should know that today NASDAQ is currently 3179.96 (on 22/09/2012). But during the dot-com bubble the market had a climax on March 10, 2000, with the NASDAQ peaking at 5132.52 in intraday trading before closing at 5048.62. More than double its value just a year before. NASDAQ Composite ultimately traced its way to a low 1114.11 losing 78% of its value and hence signified the end of many ‘innovative’ companies. So, here we can see the difference of momentum going through in that period. Most of the technology companies in the US are listed in NASDAQ. So, investors regularly refer to NASDAQ to look at the health of Tech companies. Lately, Facebook has been quoted in the NASDAQ.

Although it was a boom and bust cycle, the Internet boom is sometimes meant to refer to the steady commercial growth of the Internet with the advent of the world wide web, as exemplified by the first release of the Mosaic web browser in 1993, and continuing through the whole decade.

A combination of rapidly increasing stock prices, market confidence that the companies would turn future profits, individual speculation in stocks, and widely available venture capital created an environment in which many investors were willing to overlook traditional metrics such as P/E ratio in favor of confidence in technological advancements. This actually created the environment for the demise.

The Internet Boom began with the advent of the World Wide Web and particularly after the launch of the Mosaic Web Browser. The estimated number of users in 1995 was 18 million. The fast rise in usage and the growing publicity of the internet meant there was an untapped potential and international market. Speculators were unable to control their excitement.

Because of the unknown and innovative nature of online business, traditional business models were eschewed in favor of bold and risky models which focused on brand-building and networking in order to capture market share before profits were even considered. Venture capitalists saw record-setting growth as dot-comcompanies experienced meteoric rises in their stock prices and therefore moved faster and with less caution than usual, choosing to mitigate the risk by starting many contenders(note: Between 1999 and early 2000, the U.S. FED  increased interest rates six times) and letting the market decide which would succeed. The low interest rates in 1998–99 helped increase the start-up capital amounts. A canonical “dot-com” company’s business model relied on harnessing network effects by operating at a sustained net loss to build market share. These companies offered their services or end product for free with the expectation that they could build enough brand awareness to charge profitable rates for their services later. The motto “get big fast” reflected this strategy. Most of the companies were primarily financed by venture capital and IPO. The IPOs of internet companies emerged with frightening frequency. The novelty of these stocks, combined with the difficulty of valuing the companies, sent many stocks to dizzying heights and made the initial controllers of the company wildly rich on paper. The upward trend continued even if there weren’t any profits to show.  Market confidence that these companies would turn in future profits were huge. The Dot-com Boom reached a pinnacle in 1999. There were 457 IPOs in 1999 most of which were internet and technology related. 117 of these 457 IPOs doubled on the first day of their trading!

In spite of this, however, a few company founders made vast fortunes when their companies were bought out at an early stage in the dot-com stock market bubble. These early successes made the bubble even more buoyant. An unprecedented amount of personal investing occurred during the boom, and the press reported the phenomenon of people quitting their jobs to become full-time day traders. American news media, including respected business publications such as Forbes and the Wall Street Journal, encouraged the public to invest in risky companies, despite many of the companies’ disregard for basic financial and even legal principles.

According to dot-com theory, an Internet company’s survival depended on expanding its customer base as rapidly as possible, even if it produced large annual losses. For instance, Google and Amazon did not see any profit in their first years. Amazon was spending on expanding customer base and alerting people to its existence and Google was busy spending on creating more powerful machine capacity to serve its expanding search engine. The phrase “Get large or get lost” was the wisdom of the day. At the height of the boom, it was possible for a promising dot-com to make an initial public offering of its stock and raise a substantial amount of money even though it had never made a profit — or, in some cases, earned any revenue whatsoever. In such a situation, a company’s lifespan was measured by its burn rate: that is, the rate at which a non-profitable company lacking a viable business model ran through its capital served as the metric. Public awareness campaigns were one of the ways in which dot-coms sought to expand their customer bases. Super Bowl XXXIV in January 2000 featured 17 dot-com companies that each paid over $2 million for a 30-second spot. By contrast, in January 2001, just three dot-coms bought advertising spots during Super Bowl XXXV.

Cities all over the United States sought to become the “next Silicon Valley” by building network-enabled office space to attract Internet entrepreneurs. Communication providers, convinced that the future economy would require ubiquitous broadband access, went deeply into debt to improve their networks with high-speed equipment and fiber optic cables. Companies that produced network equipment like Nortel Networks were irrevocably damaged by such over-extension; Nortel declared bankruptcy in early 2009.

Similarly, in Europe the vast amounts of cash the mobile operators spent on 3G licenses in Germany, Italy, and the United Kingdom, for example, led them into deep debt. The investments were far out of proportion to both their current and projected cash flow, but this was not publicly acknowledged until as late as 2001 and 2002. Due to the highly networked nature of the IT industry, this quickly led to problems for small companies dependent on contracts from operators. One example is of a then Finnish mobile network company Sonera, which paid huge sums in German broadband auction then dubbed as 3G licenses. 3rd generation networks however took years to catch on and Sonera ended up as a part of TeliaSonera, then simply Telia.

Over 1999 and early 2000, the U.S. Federal Reserve increased interest rates six times, and the economy began to lose speed. When the NASDAQ started to fall,  this was attributed to correction by most market analysts; the actual reversal and subsequent bear market may have been triggered by the adverse findings of fact in the United States v. Microsoft case which was being heard in federal court.

On 20^th March 2000, after the NASDAQ had lost more than 10 percent from its peak, financial magazine Barron shocked the market with its cover story “Burning Up”. Sean Parker stated: “During the next 12 months, scores of highflying Internet upstarts will have used up all their cash. If they can’t scare up any more, they may be in for a savage shakeout. The article pointed out: “America’s 371 publicly traded Internet companies have grown to the point that they are collectively valued at $1.3 trillion, which amounts to about 8% of the entire U.S. stock market.” By 2001 the bubble was deflating at full speed indeed.

Several communication companies could not weather the financial burden and were forced to file for bankruptcy. One of the more significant players, WorldCom, was found practicing illegal accounting practices to exaggerate its profits on a yearly basis. WorldCom’s stock price fell drastically when this information went public, and it eventually filed the third-largest corporate bankruptcy in U.S. history. Other examples include NorthPoint Communications, Global Crossing, JDS Uniphase, XO Communications, and Covad Communications. Companies such as Nortel, Cisco and Corning were at a disadvantage because they relied on infrastructure that was never developed which caused the stock ofCorning to drop significantly.

Many dot-coms ran out of capital and were acquired or liquidated. Several companies and their executives were accused or convicted of fraud for misusing shareholders’ money, and the U.S. Securities and Exchange Commission fined top investment firms likeCitigroup and Merrill Lynch millions of dollars for misleading investors. A few large dot-com companies, such as Amazon.com and eBay, survived the turmoil and appear assured of long-term survival, while others such as Google have become industry-dominating mega-firms.

The stock market crash of 2000–2002 caused the loss of $5 trillion in the market value of companies from March 2000 to October 2002. Some companies, such as Pets.com, failed completely. Others lost a large portion of their market capitalization but remained stable and profitable, e.g., Cisco, whose stock declined by 86%. Some later recovered and surpassed their dot-com-bubble peaks, e.g., Amazon.com, whose stock went from 107 to 7 dollars per share, but a decade later exceeded 200.

To deal with this crisis, the Federal Reserve with its then chairman Alan Greenspan decreased the interest rate to 1% in order to boost up the economy. Although hailed as a good move was one of the main factors that contributed to the subprime mortgage crisis. Investors borrowed from the FED and would put the money in the housing market where interest rates were higher and would benefit from the arbitrage. Banks were also suddenly able to lend loan cheaply. The average difference between subprime and prime mortgage interest rates declined significantly between 2001 and 2007. Thus, we can see it was a chain of events starting from the dot-com bubble bust which actually, may be unintendedly, fueled both the housing and the credit bubble. What happened is all left for us to see.

On dropping the FED interest rate from 1.25% to 1 % in 2002, Alan Greenspan stated:

Besides sustaining the demand for new construction, mortgage markets have also been a powerful stabilizing force over the past two years of economic distress by facilitating the extraction of some of the equity that homeowners have built up over the years.

In the wake of the subprime mortgage and credit crisis in 2007, Greenspan stated that there was a bubble in the US housing market, warning in 2007 of “large double digit declines” in home values “larger than most people expect“.However, Greenspan also noted, “I really didn’t get it until very late in 2005 and 2006.”

In 1977, Greenspan obtained a Ph.D. degree in economics from New York University. His dissertation is not available from the universitysince it was removed at Greenspan’s request in 1987, when he became Chairman of the Federal Reserve Board. However, Barron’s(newspaper) has obtained a copy, and notes that it includes “a discussion of soaring housing prices and their effect on consumer spending; it even anticipates a bursting housing bubble“.

Now seriously, I don’t know! And am thinking now!