The Dotcom Bubble

What is the Dotcom Bubble?

The dotcom bubble also known as tech bubble , the internet bubble
is a stock market bubble that was caused by speculation in dotcom or
internet-based businesses from 1995 to 2000. The companies were largely
those with a “.com” domain on their internet address.

The dotcom bubble’s origins can be traced to the launch of the World Wide
Web in 1989, the subsequent establishment of internet and tech-based start-
up companies during the 1990s, and rising momentum as the decade came
to its end. The period marked the emergence of the widespread use and
adoption of the internet from shopping online, communication, and a source
of news.

Background

Historically, the dot-com boom can be seen as similar to a number of other

technology-inspired booms of the past including railroads in the 1840s,
automobiles in the early 20th century, radio in the 1920s, television in the
1940s, transistor electronics in the 1950s, computer time-sharing in the
1960s, and home computers and biotechnology in the 1980s.

UNDERSTANDING THE DOT COM BUBBLE

The dotcom bubble is also associated with the NASDAQ composite index,

which rose by 582% from 751.49 to 5,132.52 from January 1995 to March
2000. The NASDAQ fell by 75% from March 2000 to October 2002,
erasing most of the gains since the bubble started building.
National Association of Securities Dealers Automated Quotations, a computerized system for trading in
securities. (NASDAQ)
Several online and technology entities declared bankruptcy and faced
liquidation – namely Pets.co., Webvan, 360Networks, Boo.com, eToys, etc.
However, other internet-based companies struggled but survived and are
giants today, notably Microsoft, Amazon, eBay, Qualcomm, and Cisco.
Share prices of internet companies increased much faster and higher than
their peers in the real sector due mostly to speculation caused by the
excitement and euphoria of the new internet age. As a result, it led to a
market-wide over-valuation of internet firms relative to their intrinsic value.
The bursting of the bubble caused market panic through massive sell-offs of
dotcom company stocks, driving their values further down, and by 2002,
investor losses were estimated at around $5 trillion.
The upswing in the market and the change in interest in the new internet
industry, media attention and investor speculation on profits from
companies with a '.com’ domain in their internet address acted as the
triggers for this market change.
At that time, these internet-based companies experienced exponential
growth in their stock prices of over 400%.
The NASDAQ saw a steady increase in its value during the 1990s, peaking
at nearly $8,000 in 2000. However, the bubble burst in 2002, and stock
prices fell 78%. As a result of this crash, many of these companies suffered
and the US economy was hit hard.

Characteristics of the Dotcom Era

The madness of buying internet-based stocks was overwhelming, as many

internet-based companies, so-called dotcoms, were starting up. Because
they were in a fairly high-growth industry, they needed funding. Funding

came primarily from venture capitalist firms. Lenders and individual

investors also followed later.

Instead of focusing on the fundamental company analysis involving the
study of company revenue generation potential and business plans, industry
analysis, market trend analysis, and P/E ratio, many investors focused on
the wrong metrics such as traffic growth to their website propelled by the
startup companies.
Most startups did not adopt viable business models, such as cash flow
generation; hence, they were overvalued and highly speculative. It
culminated in a bubble that grew rapidly for several years.
Outrageous valuations were placed on these companies, and share prices
continued to go up as demand was overwhelming. Therefore, the bursting
of the bubble was inevitable and resulted in a market crash, which was
more conspicuous on the NASDAQ Stock Exchange.
The dotcom bubble crash was a shock event that resulted in massive sell-
offs of stocks, as demand waned and restrictions on venture financing
increased the rate of the downturn. The crash also resulted in massive
layoffs in the technology sector, as it was inevitable.
The dotcom bubble started collapsing in 1999, and the fall precipitated from
March 2000 until 2002. Several tech companies that conducted an IPO
during the era declared bankruptcy or were acquired by other companies.
Others hung by a thread as their stocks plunged to levels so low it was never
envisaged.

Causes of the Dotcom Crash

1. Overvaluation of dotcom companies

Most tech and internet companies that held IPOs during the
dotcom era were highly overvalued due to increasing demand and a lack of
solid valuation models. High multipliers were used on tech company
valuations, resulting in unrealistic values that were too optimistic.
Analysts did not focus on the fundamental analysis of these businesses, and
revenue generation capability was overlooked, as the focus was on website
traffic metrics without value addition. Research carried out revealed an
overvaluation of more than 40% of dotcom companies by studying their
P/E ratios.

2. Abundance of venture capital

Money pouring into tech and internet company start-ups by venture
capitalists and other investors was one of the major causes of the dotcom
bubble. In addition, cheap funds obtainable through very low interest rates
made capital easily accessible. It coupled with fewer barriers to acquiring
funding for internet companies led to massive investment in the sector,
which expanded the bubble even further.

3. Media frenzy

Media companies encouraged people to invest in risky tech stocks by

peddling overly optimistic expectations on future returns and the “get big
fast” mantra. Business publications – such as The Wall Street Journal,
Forbes, Bloomberg, and many investment analysis publications – spurred
demand through their media outlets adding fuel to a burning fire and further
inflating the bubble. Alan Greenspan’s speech on “irrational exuberance” in
December 1996 also set off the momentum on technological growth and
buoyancy.

Warren Buffett’s Worst Loss Came During the Dot-Com

Bubble

Buffett suffered a 49% loss from Jun 1998 to Mar 2000. At the same time,
the NASDAQ rose 140% and SP500 rose 28%. Despite heavy losses and
public ridicule, Buffett stuck to his guns and wouldn’t touch internet stocks.
Buffett’s ability to stay disciplined might be more admirable than his
analytical skill.
At the time, I’m sure people were wondering if Buffett had lost his golden
touch or if he would ever outperform the market again. A near 50% loss for
a stocks investor during the biggest bull market in history doesn’t inspire
confidence. But he had the last laugh after the bubble burst, gaining 80%
over the next two years while the NASDAQ lost 72% and SP500 lost 28%.
It takes courage to stick to your system during a losing streak, especially
when you underperform passive buy-and-holders and day traders.
Past Performance is Not Necessarily Indicative of Future Results
There is always a risk of loss in futures trading.

Dot-com bubble effects on the economy

The impact of the dot-com bubble on the economy was quite severe. Not
only did it lead to a mild recession, but it also shook confidence in the new
internet industry.
Example
Intel had stock on the financial market since the 1980s, but it plummeted
from $73 to about $20 to $30. Although the company was not directly
involved in the dot-com bubble, it was still hit hard. And as a result, it took a
long time for the stock prices to rise again.

Investing: the dot-com bubble had a greater impact on investors than on the
actual companies in the internet industry. The New York Times reported
about 48% of dot-com firms survived the crash, although most lost a
significant amount of their value.

Bankruptcy: the bursting of the dot-com bubble led to bankruptcy for

several companies. One example is WorldCom, which admitted to billions
of dollars in accounting errors, leading to a dramatic drop in its stock price.

Capital spending: while investment spending increased, savings shrank

while household borrowing increased. These savings were so low that they
were insufficient to cover the cost of the factors of production required to
meet initial investment needs.