The Formation of the Bubble

From the prospective of economics, we can usually divide the bubble into three stages. In this sector, we mainly talks about the formation of the bubble.

 

First of all, as we can see the same thing from the history, that it is not only the development of internet industry but also the mania of financial industry contributed to the formation of the dot com bubble. At that time, some of the high tech companies, like Microsoft and IBM, are both profitable and promising. They brought considerable returns to their shareholders and made people excited about the high tech companies. This motivated some internet corporations to mimic the model of the successful companies. They elaborately packaged themselves and attracted many investors with blind optimism. But the thing is that these companies cannot change the fact that they are not capable in gaining profit. Instead, they are very aggressive and use money extravagantly. Most of them do not have a feasible plan and are poor at managing. But with the new concept of “dot com”, they can still attract investors. Despite the fact that many of these companies are very unhealthy, financial institutes were trying to sell their stocks. According to Brennan (2004), agency problems in the production and sale of information played an important role in the mania of investors. And this sowed the seed of the crisis.

Having witnessed the high growth of the internet corporations, venture capitalists are no longer that cautious (Valliere 2004). IPO initial returns reached astronomical levels during 1999-2000(A Ljungqvist and WJ Wilhelm 2003). The low interest rate between 1998 - 1999 also contributed to the madness of the investors. In 1999, the total venture capital in the market made a record of $48.3B. 2/3 of it are absorbed by the internet corporate. In 1999, the market value of internet corporations is $1320B. In July 1999, the new concept stock china.com made its IPO and the same day, its price increased by 235%.

At that time, many of the internet corporation adapted a quite aggressive strategy. They maintained great deficit to capture the market shares. These companies rely much on the venture capital (same thing is happening in China now! And I will talk about it later). As it is hard to value the new internet corporations, their stock prices are made unbelievable and their initial shareholders are quite wealthy.

 

In October 11, the market value of Cisco exceeded Intel (Buffett ever purchased the shares of Intel and this can make some sense of the characteristic of this company), which made them the highest value company in Silicon Valley. In the next blog, I’ll go on with the story and to talk about the second stage: How it developed into a bubble.

 

Reference:
 

Ljungqvist, Alexander, and William J. Wilhelm Jr. "IPO pricing in the dot‐com bubble." The Journal of Finance 58.2 (2003): 723-752.

 

Brennan, Michael J. "How did it happen?" Economic Notes 33.1 (2004): 3-22.

Valliere, Dave, and Rein Peterson. "Inflating the bubble: examining dot-com investor behaviour." Venture Capital 6.1 (2004): 1-22.