What Caused the Dot Com Bubble: 1: Bubble, Credit and Monetary Policy

From this sector, we are going to talk about the main causes of the dot com bubble. In my bog, three factors are going to be talked about. First of all, the relationship between the bubble and the credit will be talked about.

 

There are a wide variety of reasons that can result in a bubble, both inevitable reasons and accidental reasons. Early researches have been focused on the irrationality of the investors and this will be mentioned later. But along with the development and the liberalization of the financial market, it became very important to analyse its role in the bubbles.  Monetary policy toward the asset bubbles has always been a controversy of the economist.  Some of the economist proposed that the reaction of the financial market should be taken into consideration when making the monetary policy. But some others cannot agree with the idea.  There is also controversy among the people who think it is necessary to take the financial market into consideration when making the monetary policy. Some of them think the policy should be an ex-ant action while the others think it should be an ex-post one.

 

“Standard theories of asset pricing assume that investors purchase asset with their own wealth. In most financial systems, this is not the whole story .Intermediation is important. Many of the agents buying real estate, stock and other assets do so with other people’s money (Allen and Gale).” This is really the case during the dot com bubble. During that time, investors borrowed large amount of money buying new shares. The dot com corporations borrowed money to expand. And they did these in an extreme way. This really led to the formation of the bubble.

 

Allen and Gale (1999) suggested that the relationship between credit and asset prices becomes even more complex in a dynamic context. And they suggested that the uncertainty about the level of credit can further aggravate the bubble “the more uncertainty that is with the future credit, the more uncertainty the future price will be. Because of the risk-shifting problem, uncertainty makes the asset price more attractive to the debt-financed investors.” The process of the formation of the dot com bubble is also the process of the increase of the uncertainty. This also implies that a signal of tighten the credit can be very likely to lead to the burst of the bubble.

 

But the story is not that easy. It’s not like that: ease credit and bubble form while tighten credit and bubble burst. In fact, bubble and prosperity is like the two sides of a coin. In the next bog, I’ll talk something about the Mississippi bubble and John Law. Compared with dot com bubble it is relatively innocent. Only then, it can help us to clearly observe the role which money played in the bubble, and more important, in the economy.

 

Allen, F. and Gale, D. (1999) “Bubbles, Crises, and Policy”, Oxford Review of Economic Policy, 15, 9-19.

Allen, F. and Gale, D. (2000) “Asset Price Bubbles and Stock Market Interlinkages”, mimeo.

The Burst of the Dot Com Bubble

In March 10, 2000, the NASDAQ index dropped from 5132 to 5048.62.  The market analyst thinks it is only a small correction of the market. But it turned out to be the beginning of the disaster.  From that day, the index began to decrease at an average speed of 11.3%. After 18 months, the investors were done in the dump.

 

 

It was like a dream of investors of NASDAQ index, from October 8, 1998 to September 21, 2011. They dreamed that the index reached 5130 point. But after waking up, it found that the index was still at 1420 point.

There are several incentives for the whole collapse like:

Large sells of leader enterprises appeared in March 10, 2000. This not only led to a chain reaction, but also raised panic.

Microsoft was accused of monopoly in 1997 and Gates resigned in January, 2000. In April 2000, the court declared that they have found evidence of the behaviour of monopoly of Microsoft. Microsoft was faced with being split off at that time. This further increased the panic.

Top analyst of Goldman Sach suggested to underweight the stock of internet corporations, which was the first time in 10 years.

Wrong incentives at wrong time as long as the underlying problems that did exist led to the eruption of the crisis. The stock price that used to be quite unreasonable began to fall. Companies that made their living by being financed can no longer find the money. Many companies were shuttered and many IT engineers lost their jobs.


When the dot com companies run out of money, most of them were being merged or wind up. Big financial institutes like Citi and Merrill Lynch were fined for mislead the investors (we will talk about it later).  More than $5000B fund were evaporated from the stock market between March 2000 and October 2002. According to the recent research, there were only 50% companies survived after 2004, like Amazon and EBay.

Since then, IT industry seems no longer be the focus of the society. An interesting phenomenon is that after the dot com bubble, fewer students want to gain a degree of computer engineering. In the 1990s, enrollments grew rapidly in information systems and computer science. Then, beginning in 2000 and 2001, enrollments declined precipitously (Panko 2008).

But after that, where do moneys go? The housing market?

So far, we have talked about the three stages of the dot com bubble. We’ll talk about what caused the dot com bubble in the following days. In the next blog, I’ll work into details about the relationship between the dot com bubble and condition of the credit market at that time.

Reference:

 

Panko, Raymond R. "IT employment prospects: beyond the dotcom bubble." European Journal of Information Systems 17.3 (2008): 182-197.

Crazy Things in the Crazy Year

Silicon Valley life in the dot com bubble

Driving from San Francisco to San Jose takes 90mins, and that’s not during the rush hour!

No matter it is breakfast, lunch or supper, eating in the restaurant became a torment. It is common to wait for more than 45mins.

Finding a house here during the dot com bubble? That’s almost impossible. Even before 1997 when the bubble hasn’t totally formed yet, different kinds of people came to the Silicon Valley to rent house. At that time, you can ask them to do anything if you can provide them with a house.

Want to buy a car? You’d better go to Oregon. Car dealers in the Silicon Valley were having a very long waiting list.

Absurd Business Ideas

The business ideas of many online pet suppliers are to instigate the consumers to buy lots of dog food or cat litter online, and deliver them for free. The high freight as long as the large expense spent on advertising made some of them close done. Among them, Pets.com is the most famous one. It had its IPO in 1999 and closed done in 2000.

Another website, Kozmo.com. Firstly they promised to deliver the good in one hour in New York, for free. Deliverymen usually ride a bike to do this. That seems to be quite successful. But after they have expanded their market, they wanted to continue with the idea of delivery free in one hour in the whole country! That led to great transportation cost and the company closed done in 2001.

Tragedy of profligacy

During the peak of dot com bubble. A founder of a Com company who was very wealthy after the IPO of his company bought a lot of real estates. In the year when he was 39, he lost his life and the lives of his two other friends with his world class sports car. At that time, he was being accused of drug taking and raping.

An online video venture, spent $12M to celebrate its start business. In fact, the founder of company is an escaped criminal. He made lots of money during the dot com bubble. But after the burst of the bubble, his company went bankrupt. And he had to surrender himself to the law.

 

The Development of the Dot Com Bubble

There is a natural defect of the Com model. Loads of companies in the same field have the same business plan, which is mainly to seize the market by utilizing the network effect. It is obvious that usually there are few winners in the same field. And most of them will not succeed.

 

During that period, many companies used all sort of means to expand their customer base at great cost. Some companies just named themselves with a meaningless onomatopoeia (like Yahoo!), which aims to distinguish itself from the others. The 34^th super bowl was held in 2000, which was sponsored by 17 internet corporations. Each spent more than $2M put their ads only in 30 seconds. At the other extreme, in 2001, it was only sponsored by 3 internet corporations.

 

It is no surprise that because of the market mania at the time, many companies began to spend money like water. They bought luxurious facilities, provide their stuff with gorgeous holidays and give their stuff options rather than cash. Many of them became very wealthy when having launched their IPOs. And they invest on the other internet corporations with their new wealth.

 

Almost all the cities in the US are building themselves with more networked workspace. They want to become the next Silicon Valley. Communication providers believe there will be a great demand for their product in the future and they tend to maintain a high leverage. As a result, companies that produce these facilities gained a lot, like Cisco. These all together formed a cycle. So on and so forth.

 

This is quite similar with what is happening in China now. In the spirit of ShanZhai (cheap copy?). Many internet companies are trying to become the next Facebook, Twitter or YouTube. They think there is a large potential market and they have accumulated much experience during the last decade. They think they have learnt enough from the lesson of dot com bubble. They think “this time, this situation, it is different”. They think …… All of this created a similar flavour of the past. We’ll look into details about it later. In my next blog, we will see the third stage: How the dot com bubbles burst.

 

 

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.

The Brewing Crisis

Bubbles should not only be viewed as an economic phenomena, it should also be viewed as a social phenomenon. From the prospect of history, almost every bubble is accompanied with a peculiar trend of thought of the society. The dot com bubble is typically such a kind of bubble.

The human civilization has experienced five thousand years of agricultural civilization era, and experienced three hundred years of industrial civilization era. People will naturally think that the pace of the civilization is accelerated. On the occasion of the new millennium, the whole world is wishing a glorious future.

 

In 1994, the appearance of World Wide Web browser and Mosaic makes the Internet began to attract the attention of the public. In 1996, most of the listed companies in the United States own a public web site as necessities. People began to notice that the Internet can deliver information freely and are accessible to worldwide information as well as some other wonderful characteristics. These concepts attracted a lot of young people. They think the internet-based new business model will rise and they expect to become the first to earn money. Internet can lower the cost to contact with customer all over the world. Traditional business model has been greatly changed in the new form of advertising, selling and customer relationship managing. The Internet has brought a new business model which is still not possible several years ago. This, will of course draw the attention of venture capital.

The foundation of the development of the internet is not core technics, it is even not the capital, but the user. Once the users of internet get to know about the internet and be used to it, he can never live without it. From the prospect of economics, capital market is not isolated but an internal recycle system, like metabolism. The capital inflow to the internet business will outflow back to the to the capital market in the form of consumption of individuals. This means the investment of internet business is after all from each of the individuals which use the internet. As the old saying goes: Many a little makes a mickle. The source of wealth of internet business seems very steady and considerable. All these make the business about internet very attractive.

For investors, no dream is bigger and more realistic. At this very moment, in the stock market, www is like a Pandora’s Box. Releasing hope, but finally, as well as woe. In the next blog, let’s look into details about the formation of the bubble!

 

Introduction: The Research of Dot Com Bubble

Financial market is inherently instable but financial market has a learning mechanism. Forms of bubbles in the history are various but there is something invariant underlying these bubbles. And the thing is humanity. When moral hazard and adverse selection increased, things will go wrong. And one of the forms of it is a bubble.

 

It is not easy to define bubble as Peter Garber ever said that that bubble is “a fuzzy word filled with import but any operational definition.” Many economists tried to give a definition of bubble. Charles Kindleberger ever defined it as “a bubble is an upward price movement over an extended range that then implodes (Manias, Crashes and Panics).” “Bubbles are typically associated with dramatic asset price increases, followed by a collapse (Brunnermeier 2007)”. Among them, I like Peter Garber’s definition most (several economist defined it in this way like Mishkin and Eakins (2006)). He said that a bubble can be viewed as “a price movement that is inexplicable based on fundamentals.” I like it because it mentioned fundamentals. And fundamental is a concept valued by value investors and should be kept in mind by every investors.

 

Each of the bubble in the history is with lots of stories. Holland’s Tulip Mania can be traced back to 17^th but before that, such things did happened. The Mississippi bubble of 1720s had a profound effect. John Law, a superb gambler, whose financial theory has inspired generations of economists. Newton signed that “I can calculate the motions of heavenly bodies, but not the madness of people” after a failed investment in the South Sea bubble. Railway mania in 1840s and dot com bubble in the beginning of the C21th are brought by the new technology. Stock price bubbles and housing bobbles have taken place and are taking place in different places in the world under different circumstances.

 

 Each time I read again The intelligent investor, I couldn’t help thinking “What valuable comment Graham will give after the dot com bubble if this generous man is still alive?” This definitely motivated me to research into details about the dot com bubble. In my bog, I will explore what causes the dot com bubble combined with

the former research results. I will also explore what is the similarity of dot com bubble compared with other bubbles and what is the distinct place of it compared with others. At the end of the series of blogs, I will try to give some ideas with this bubble in Graham’s way and try to see if we can learn more from this bubble.

Reference:

 

Kindleberger, Charles P., and Robert Z. Aliber. Manias, panics and crashes: a history of financial crises. Palgrave Macmillan, 2011.

 

Mishkin, Frederic S., and Stanley G. Eakins. Financial markets and institutions. Pearson Education India, 2006.

 

Durlauf, Steven N., and Lawrence Blume, eds. "The new Palgrave dictionary of economics." (2008).

 

Garber, Peter M. "Famous first bubbles: the fundamentals of early mania." (2000).