Loading...

Rise and Burst of the Dotcom Bubble

Causes, Characteristics, Examples

Seminar Paper 2012 27 Pages

Business economics - Banking, Stock Exchanges, Insurance, Accounting

Excerpt

Table of Contents

List of Figures and Tables

List of Acronyms and Abbreviations

1 Introduction

2 Causes and Characteristics of Financial Bubbles

3 The Dotcom Bubble
3.1 Rise and Growth of the Bubble
3.2 Burst of the Bubble

4 Company Examples
4.1 Losers
4.2 Survivors

5 Conclusion and Outlook

Bibliography

Appendix

Declaration

List of Figures and Tables

Figure 1: Development of NASDAQ from 1995-2005

Figure 2: How financial bubbles expand

Figure 3: How financial bubbles contract

Table 1: Causes of speculative bubbles

Table 2: A description of the timeline for the Dotcom bubble

List of Acronyms and Abbreviations

illustration not visible in this excerpt

1 Introduction

The Dotcom bubble, also known as the ‘Internet bubble’ or the ‘Information technology bubble’[1] was a speculative bubble of stock prices of mainly American Internet companies during the time from 1995 until 2000 when many investors believed that a ‘new era’ was upon them.[2] In only two years, the Internet sector grew over 1000% of its public equity and equalled nearly 6% of the market capitalization of the United States and over 20% of all public traded equity volume in the US.[3] It had its peak on March 10, 2000 with a NASDAQ score of 5,048.62 (see figure 1). This period was characterized by lots of establishments of companies in the Internet sector. They were called ‘Dotcom Companies’ because of the ‘.com’ in the end of an URL that comes from the word ‘commercial’.

The bubble burst during the years 2000 until 2002 when the NASDAQ lost nearly 80% of its value, many companies like Pets.com failed completely and over $7 trillion in market value were destroyed.[4]

With this paper, the authors try to explain the rise and fall of Internet stock prices during that period. For this purpose, the general causes and characteristics of financial bubbles get described before the application to the Dotcom bubble follows. Additionally, some company examples and survivors and losers of the bubble like pets.com, Webvan or Ebay get introduced. Because the bubble mainly took place in the United States, the Authors will focus on American company examples and the American stock exchange.

2 Causes and Characteristics of Financial Bubbles

The term ‘economic’ or ‘speculative bubble’ describes “a situation where asset prices rise above levels justified by economic fundamentals.”[5] Those fundamentals are measured in terms of the discounted future cash flows that the assets could potentially create. During speculative bubbles the asset prices rise more and more until the point is reached where they cannot be justified by fundamentals anymore: They rise far over their realistic value. This goes on until some special event prevents buying more of these assets. What follows is a bottomless price decline.[6]

There exist various speculations about the initial causes of these bubbles (see table 1). One thing that is certain is that there often exists an irrational enthusiasm at the stock exchange that supports that asset prices escalate. Throughout those price escalations investors get influenced by ‘feedback effects’, e.g. when a share that they own rises in prices or when other investors make big amounts of money. “The fact that so many people are participating in the scheme makes it appear safe at the same time that the perception that others are getting rich makes it appear too good to pass up.”[7] This leads to the situation that more and more investors appear at the market and bid up prices higher and higher. “Soon the whole market becomes convinced that the old fundamentals of valuation no longer apply and that the world has entered a ‘new era’. The future is conceived of as something fundamentally different from (and better than) the past.”[8]

There is a strong over-confidence and believe that the price level will never go down again. A vicious circle arises: Investors explain price increases trough a visionary, nearly pathetic cause, for instance the ‘new era’. Nobody seems to understand that the prices escalate because of the increasing buying activities of the investors themselves.[9]

In his book ‘Irrational Exuberance’, Robert J. Shiller explains that people are often influenced by group dynamics in their behaviour. He argues that the behaviour of the individual would be viewed as being rational, but when it gets influenced by the behaviour of others, it can produce an irrational result. This phenomenon is called ‘herd behaviour’. Shiller blames ‘information cascades’ for the herd behaviour, which he describes as the reliance of an individual on someone else’s decisions.[10]

This herd behaviour is also often influenced by emotions. The trust in other people mixed with greed leads people to buy stocks in times of a rising financial bubble.[11]

The bubble gets bigger and bigger, but also more and more fragile. At some point, a certain mechanism causes the burst of the bubble and let the prices decrease rapidly, just like the Dotcom bubble.

3 The Dotcom Bubble

Financial bubbles can be divided in three time periods: The period prior to the main bubble (‘pre-bubble’), the period where the bubble actually takes place (‘bubble’) and finally the period when the bubble bursts and the capital market turns down (‘bubble-burst’).[12] The pre-bubble period of the Dotcom bubble went from 1995 to 1997, the actual bubble took place from 1998 until March 2000 and the bubble-burst from March 2000 until the low-point of the NASDAQ score in October 2002 (see figure 1). After that period, the stock exchanges slowly recovered.

Since 1995, more and more American start-up Internet companies issued shares and were therefore listed in the American stock exchange NASDAQ. People had enormous expectations about the Internet technology itself as it would change the whole corporate landscape and the entire way business was done. The general opinion was that Internet companies had fantastic opportunities.[13]

The American economist Robert J. Shiller describes the general mood that was related to the uprising Internet era in the following way:

“Internet technology is unusual in that it is a source of entertainment and preoccupation for us all. In this sense, it is comparable in importance to the personal computer or, before that, the television. In fact, the impression it conveys of a changed future is even more vivid than that produced when televisions or personal computers entered the home. Using the Internet gives people a sense of mastery of the world. They can electronically roam the world and accomplish tasks that would have been impossible before. They can even put up a website and become a factor in the world economy themselves in previously unimaginable ways. [...] Because of the vivid and immediate personal impression the Internet makes, people find it plausible to assume that it also has great economic importance.”[14]

What can be read out of those words is that a major invention of mankind was about to come up. That is the reason why in the end of the 1990’s, more and more Internet companies were founded and financed by investors that ran after the general Internet hysteria.

Companies issued shares to get even more funding. The speculative bubble of NASDAQ between 1995 and 2000 led to an enormous rise in stock prices of high-technology companies with a spill over from the technology sector towards sectors like finance, trading and services.[15] Many companies with no history, very low sales and nearly no profits captured billions of USD in market capitalization.[16] Such a growth without profitability was everything but sustainable. In March 2000, the markets broke down. A bubble that had been growing for six years suddenly popped. The NASDAQ index fall down 39% just in 2000. It continued to decline down to a score of 1,114 on October 9, 2002 (see figure 1).

3.1 Rise and Growth of the Bubble

The first company in the Internet sector that issued shares at the stock exchange was Netscape Communications Corporation, developers of a web browser. The Initial Public Offering (IPO) took place on August 9, 1995.[17] Therefore, this date can be considered as the start of the Dotcom bubble.

One major reason for the enormous growth of the asset prices of the NASDAQ is that the American Federal Reserve lowered its interest rates in the mid 1990s. That helped to increase the start-up capital amounts and encouraged venture capitalists to aggressively invest in Internet start-up companies.[18]

Internet companies have been viewed as being different from traditional companies because of the unlimited opportunities that new technology could bring. “However, investors purchased Internet company shares for the same reasons that they purchase traditional company shares: to participate in the future earnings of the company.”[19]

Figure 2 shows how financial bubbles expand. Exactly the same procedure took place during the Dotcom bubble: During the period of the financial bubble, asset prices rose. This led to more paper wealth, which led to more investment and consumption spending. Also, banks had stronger balance sheets, which led to more lending. Investors bought stocks to profit from the rising prices. All those factors resulted in accelerated asset price rises.

The problem of that belief was that most of the business models were based on intangible concepts (see chapter 4) and therefore linked with a certain risk of failure. But during the rise of the Dotcom bubble, nobody thought about that risk. The British author and journalist Alex Preston wrote about that time: “It was as if old-economy corporations were making reparations for the doubts they had aired about the brilliance of these baseball-cap-wearing neophytes and their incomprehensible netspeak. The young companies did not need to be profitable; they barely needed to exist. A flashy cascading PowerPoint presentation was enough to make the suits reach for their wallets. Old- industry firms always paid in cash – in this new world, their shares were worthless.”[20]

The supernaturally high price levels in the bubble period had been brought on by structural, cultural and psychological factors, including everything from new technology to “new era” thinking up to the over‐confidence of investors and herd behaviour.[21]

3.2 Burst of the Bubble

After lowing their interest rates in the mid 1990s, the American Federal Reserve increased them nearly six times in early 2000.[22] That was a major reason why the economy began to lose strength.

The numerical burst of the Dotcom bubble began as just said before on Friday, March 10, 2000 with a NASDAQ score of 5,048.62, which was a score more than twice as large as one year before. But the majority did not know about the bursting bubble and what was going on these days.

[...]


[1] cf. Galbraith, Hale (2004), p. 6

[2] cf. Guttman (2009), p. 54

[3] cf. Ofek, Richardson (2003), p. 265

[4] cf. Gray, Frieder, Clark (2007), p. 885

[5] Aburjanidze, Boucher (2010), p. 3

[6] cf. Lansing (2007), p. 2; cf. Aburjanidze, Boucher (2010), p. 3

[7] Lansing (2007), p. 2

[8] Aburjanidze, Boucher (2010), p. 4

[9] cf. Shiller (2006), p. 37

[10] cf. Shiller (2006), p. 149-153.

[11] cf. Brunnermeier (2001), p. 55-58.

[12] cf. Aharona, Gaviousa, Yosef (2010), p. 456

[13] cf. Guttman (2009), p. 54

[14] Shiller (2006), p. 38-39

[15] cf. Ofek, Richardson (2003), p. 265

[16] cf. Aburjanidze, Boucher (2010), p. 5

[17] cf. Corr (2007), p. 66

[18] cf. www.myrealestatebubble.com (20.05.2012)

[19] Corr (2007), p. 70

[20] Preston (2011), p. 19

[21] cf. Shiller (2006), p. 152.

[22] cf. www.myrealestatebubble.com (20.05.2012)

Details

Pages
27
Year
2012
ISBN (eBook)
9783656232957
ISBN (Book)
9783656234142
File size
781 KB
Language
English
Catalog Number
v197166
Institution / College
Technical University of Applied Sciences Mittelhessen
Grade
1,3
Tags
Dotcom Dot Com Dot-Com Bubble Financial Pets.com Rise Burst Causes Characteristics Examples

Author

Share

Previous

Title: Rise and Burst of the Dotcom Bubble