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Rise and Fall: Lessons from the Internet Bubbleby Mark Lovewell
Speculative Manias in History Economists assume individual decision-makers are rational. However this assumption can be broken. The boom and bust in Internet stocks between 1995 and 2000 is a good illustration of seemingly irrational behavior, when otherwise level-headed people allow themselves to be swept up in a speculative mania. Either through greed or short-sightedness, individuals allow themselves to believe that the price of some commodity will keep rising, despite the laws of demand and supply. Sooner or later, each of these speculative manias has come to an end, as sky-high prices fall to earth with breath-taking speed. One of the best-known cases occurred in Britain during 1720. This involved the South Sea Company, which had agreed to take over all of the British government's debt, by converting it into its own shares. Due to a misguided impression that this scheme would provide a steady stream of profit to South Sea's shareholders, a popular frenzy caused the company's share price to soar by 1000 percent in just a few months. By the time the frenzy subsided, and the share price had tumbled, numerous small shareholders had lost their fortunes, leading one observer to remark that it had "almost become unfashionable not to be bankrupt."1 The South Sea Bubble is not the only example of a speculative mania from history. Other cases include tulip bulbs in Holland during the 1630s, the New York stockmarket in the 1920s, and the Japanese property boom during the 1980s. What caused Internet stocks during the late 1990s to fit into the same pattern?
The Commercialization of Internet The Internet first made its appearance in the late 1960s, when it was a small computer network linking American universities involved in military research. Scientists and computer buffs were the main users until the early 1990s, when the creation of the World Wide Web by British software developer Tim Berners-Lee made the Internet a more accessible and flexible tool. Soon, usage rates began to skyrocket, and the Internet's revolutionary potential was finally recognized. Users were quick to appreciate the Web's commercial possibilities, and by the mid-1990s, an array of new companies had started to harness its profit-making potential. Some of these companies, such as Netscape, specialized in software. Others, such as Amazon, focused on retail sales. Yet others, such as Yahoo!, delivered information. Like all new businesses, these firms needed funds, and many of them raised money by issuing shares. Typically a share price is based on the flow of dividends that shareowners can expect to receive. There is no fixed relationship between a share price and the firm's earnings, but these new companies benefited from the fact that the Internet was viewed as a high-growth sector, so that their shares commanded a high price, based on the presumption that earnings, and dividends, would quickly expand. The fact that most of these firms were making a loss, and did not pay dividends, did not seem to affect this optimism.
The Internet Boom In the latter half of the 1990s, Internet stock prices were volatile, but gradually climbed ever higher. Share prices of early companies such as Yahoo!, America Online, and Amazon.com reached astronomical heights, which caused a host of new companies to enter the fray. These new businesses offered every conceivable profit-making venture related to the Internet, from online auction houses and gambling casinos, to do-it-yourself travel booking and stock-trading. As the boom gathered steam, large returns were often made by shareholders on the day an Internet company's shares were first issued. In many cases, these initial public offerings (IPOs) led to price increases of 100 percent or more within a few hours. The exact business these new companies were entering was usually little understood, or only sketchily researched. But in the euphoria of the moment, such facts were of little relevance. As long as shareholders were assured that there were others willing to pay even more than they did for overinflated financial assets, these high returns continued. By the end of the 1990s, more and more hardy individuals were giving up their regular jobs so that they could become full-time "day traders." Many others made trading in Internet stocks a time-consuming hobby as the party intensified. The makings of a crash were almost complete.
The 2000 Crash Ironically, the crash occurred just a few months after the end of the 1990s, as the realization grew that the amount of money being spent by consumers on the Internet could never support such high share valuations, even with healthy growth rates. Moreover, it became increasingly clear that the competitive trends at work in online commerce often meant low margins and markup percentages. In March 2000, Internet stocks started to tumble, and in succeeding weeks the fall continued. This drop was worsened by the extent to which many shareholders had speculated "on margin", which meant their share purchases had been made with funds borrowed from stockbrokers. As prices for Internet shares tumbled, shares in these margin accounts had to be sold, putting further downward pressure on prices. By mid-April, the drop in Internet shares became a rout. The Nasdaq index, on which many Internet companies were listed, had fallen from over 5000 in March to just above 3300, or by a third from its highpoint. The percentage drop for many individual Internet companies was far larger.2 Since then, the Nasdaq has fallen more, at one point dropping to a range of 1500. The index, and the prices of Internet stocks within it, may rise with an economic recovery, but they will likely take years to return to their former levels.
Lessons from the Bubble The immediate lesson of these events is that speculative manias continue to occur. Hopefully those shareholders who were part of the Internet Bubble will be much more careful in the future when dealing with stockmarket speculation. But more importantly, what does the Internet Bubble tell us about the prospects for the New Economy? And does the 2000 crash mean that e-commerce is of minor significance? Not necessarily, say many economists. Initial enthusiasm over the potential of e-commerce may have been wildly overdone, but the Internet is nonetheless having a major effect on economies such as Canada's, as its use by both consumers and businesses continues to expand. Instead of leading to vast profits for a small group of companies, however, the Internet's impact is more indirect, as a wide range of companies are slowly adjusting their operations to take account of the Internet's potential. Over time, this will increase competition in many markets, while gradually raising productivity levels. In some industries, such as music and travel, the transformations have already been substantial. And other industries will face similar changes in the future. Even though the lure of quick profits associated with Internet stocks turned out to be an unachievable dream, therefore, the long term impact of the Internet is far from over.
Notes
If directed to do so by your instructor, the following questions can be answered online and emailed to him/her or yourself.
Many economists blame the Federal Reserve, and its governor Alan Greenspan, for prolonging the Internet boom, by not raising interest rates the late 1990s. Explain how low interest rates helped keep Internet share prices high.
What aspects of e-commerce markets can lead to low economic profits for companies in these markets? Are there any other elements in these markets that can lead to high long-term profits for certain companies?
