The Dotcom Boom and Bust

Originally published on February 27, 2018

The dotcom bubble is the World War I of recent market crashes. Smaller and not as well-known, they both hide in the shadow of their huge earth-shaking brother that followed them a few years later. The dotcom boom defined the infant years of the internet when websites were popping up from thin air and attempting to make a profit off of anything and everything across this new worldwide medium. For those companies in the general technology industry, the stock market was believed to be a bubble from the years 1995 to 2001. However, the term bubble is somewhat controversial; many experts disagree on what specifically is defined as a bubble. According to Business Insider, a bubble exists when prices of an asset skyrocket and then suddenly plummet over a period of time at higher growth of income rates than what is reasonably expected.

Justin Fox at Harvard Business Review brings forward another definition accredited to Markus Brunnermaier which states, “bubbles are typically associated with dramatic asset price increases followed by a collapse. Bubbles arise if the price exceeds the asset’s fundamental value.” To put it simply, , bubbles can be explained by overvaluation of whatever the asset in question is.

Obviously, the dotcom boom was caused by the massive public use of the internet and its rapid user growth. With growth of users came growth of websites and technology companies, many of which included the “.com” suffix, giving the speculation bubble its name. Venture capitalists saw the growing user base of the internet as a source of huge profit, and they invested their money into the growing tech industry.

Market experts designate the start of the bubble in 1995 with the IPO of Netscape, which started at $28 per share and skyrocketed further to $71 after the first day of trading. From there, many more technology companies became public and saw similar soaring share prices in their first days on the market.

Throughout the late 1990s, venture capital money was being poured into internet startups. As other investors saw the volume of cash flowing to the technology sector, they decided to join the bandwagon and themselves began to invest. As time went on, investors threw their money at anything that seemed even tangentially related to the world-wide web. There were massive amounts of speculation among hopeful investors, which inevitably led to an overvaluation technology companies on the market. For example, Cisco (CSCO) was trading at just under $10 in January of 1998, and two years later, its stock was valued at an astonishing $77.

Another impetus for the speculative bubble was the tax regulation adjustments passed in 1997 known as the Taxpayer Relief Act. The new legislation lowered minimum tax rates for capital gains from 28 percent to 20 percent, which was quite beneficial for stock investors. A small yet significant feature of the new regulation was that it did not change the rate on dividend tax rates (i.e. the tax rate applied to the periodical payouts that public companies give to its shareholders) Because of this, volatility increased more on low- or no-divided shares as compared to stocks that pay higher dividends. This means that investors opted to put their money into more stocks with low dividend payouts because they wouldn’t pay as much in taxes on capital gains when compared to taxes for capital gains on higher dividend paying stocks. In fact, between the years 1997 and 2001, the percentage of S&P 500 companies that paid dividends plummeted as more companies who did not compensate investors gained more market value. Not surprisingly, many of the new technology startups were in this upcoming group.

The media had a huge influence in the gold rush for tech investments. Since almost everyone in the United States has some access to the media, the news of the skyrocketing dotcoms was well-diffused into American society, which prompted more investors, especially rather inexperienced household investors new to the stock market, to put their money into these “cash cows.” More and more average joes began to put their wages and salaries into the tech industry. The excitement and exuberance spurred on by media played a significant role in the development of the bubble and its widespread effect throughout the U.S.

The dotcom companies that popped up during this period stressed growth over profit, which led to huge expenditures on advertising and little to no actual gross profit. During the Super Bowl in 2000, 16 dotcom companies aired enormously costly commercials in order to get their name out. The notorious Pets.com aired commercials across multiple Super Bowls featuring a goofy hand-puppet dog. Although it is common for technology companies to operate for years without turning a profit, many of these dotcom companies expended perhaps too boldly and without fully considering the consequences.

The boom reached its peak in the first few months of the century, and it was followed by a sharp price drop in technology companies. At its crux in March 2000, The NASDAQ Composite, an index for public technology companies, was at 5048.62, a mark that it did not hit again until 2015. Yet, this was the turning point for almost all dotcom companies, even the ones that survived like Amazon.com. Due to a lack in any more venture capital funding, the dotcoms began to burn through their assets until they arrived at bankruptcy. Amazon, valued at $105 per share at its peak in 1999, fell to as low as $8 after the crash in 2001.

The crash caused hundreds of dotcom companies to go bankrupt. It set back most technology companies for more than a decade, only returning to peak market capitalization levels just recently. Complementary industries to the technology industry saw a scaling back in operation levels due to the decrease in demand for their services. Although the dotcom crash’s effects were not as far-reaching, the U.S. economy still required time to recover, especially after the 2001 terrorist attacks on the World Trade Center.

One would expect that the financial world would be less susceptible to bubbles such as the dotcom bubble, but as the saying goes: those who do not learn from history are doomed to repeat it. Within only a matter of seven short years, the U.S. economy found its way to another bubble and resulting crisis, this time with a bigger legacy. Just as the Great War was followed by something even greater, the dotcom bust was only a blip compared to his brother: the housing bubble of 2008.

Sources:

Beattie, Andrew. “Market Crashes: The Dotcom Crash (2000-2002).” Investopedia, 20 Nov. 2017.

Brunnermeier, Markus K. “Bubbles and Central Banks: Historical Perspectives.”Princeton University, 21 Jan. 2015.

“Dotcom Bubble.” Investopedia, 17 May 2016.

Fox, Justin. “What's That You're Calling a Bubble?” Harvard Business Review, 1 Nov. 2014.

“Here's Why The Dot Com Bubble Began And Why It Popped.”Business Insider, Business Insider, 15 Dec. 2010.