Dubbed the Internet bubble, the dot com bubble burst of 2000 is one of the most significant stock market crashes in recent history. The growth and adoption of the internet drove speculation on internet-related stocks from 1995 to 2000, with the Nasdaq rising over five fold, before tumbling over 80% by the last quarter of 2002. The plunge led to the collapse of numerous technology and internet-based companies, the majority of which had leveraged the internet to offer shopping, communication, and news delivery services. It would take a while for investors and other market participants to accept that companies can indeed generate revenues and profits on the internet.
In 1989, the World Wide Web was launched, and by mid-1991, it went live to the public. A ‘new world order’ was being launched, and internet penetration and adoption picked up pace from 1993 when browsers available to the public were launched. Naturally, the commercialisation of the internet quickly took centre stage. New start-ups emerged every other day, with big money quickly flowing to companies that were seen as taking their space in the Information Age.
Basically, any company with a dot com (.com) extension or suffix in its name was capable of attracting huge financial and speculative backing. It was also a period of easy money in the United States. A legislative act in 1997 had cut tax liability on capital gains, making investors more willing to take on speculative bets in the markets. Combined with the fear of missing out on the ‘next big internet thing’, investors literally lost their guard when opening their wallets to internet companies.
Dotcom companies had huge budgets and spent the bulk of it on advertising. Investors did not really consider fundamentals, believing that such companies will deliver huge profits in the future. Internet companies then started getting listed on stock exchanges, and the Nasdaq Composite index, which is primarily made up of technology companies, became one of the most followed on Wall Street. The index eventually became the picture of the dotcom bubble and its burst. It crossed the 1,000-point mark for the first time in 1995, and peaked at above 5,100 by early 2000, before collapsing to lows of circa 1,100 by late 2002.
How the Dotcom Bubble Burst
There were concerns that the turn of the millennium would lead to some massive computer hitches due to computers switching from the two-digit year ’99 to ’00. But by January 1st, 2000, this proved to be no source of risk because of prior preparations made to avert the bug. The bubble continued to be accelerated that year, with dotcom companies dominating the headlines. In early January, America Online and Time Warner announced a mega-merger. And in the big event, the Super Bowl of 2000, dotcom companies ran over 20% of the ads, having only made two ads the previous year. The crazy frenzy of buying internet-based stocks, and at the peak of the bubble on March 10th, 2000, the combined value of Nasdaq stocks was more than $6.7 trillion.
Then the bubble burst!
The market started declining on March 11th, 2000, and many fundamental headwinds started piling more and more pressure on stocks. The news hit the wires that Japan was entering a recession, while in the USA, a merger deal between Yahoo and eBay had collapsed. Tech giant Microsoft also lost a major court battle as investors increasingly became aware of the risks posed by technology stocks. Capital flowed out of the ‘bubble stocks’ and flowed into established companies with solid business models. Investors now started questioning and investigating the real fundamentals of tech companies. Just a month from the March 2000 peak, the Nasdaq has lost about $1 trillion in investment value.
Now firmly under the spotlight, dotcom companies started becoming more fiscally responsible. But it was too little too late. Most of the companies had fallen into bankruptcies, with the highlight being the shutdown of Pets.com in November 2000. The company had been listed just nine months earlier and enjoyed the backing of Amazon.com. Most tech companies at the time had already lost over 75% of their value, and the crash extended into 2001. The Super Bowl that year saw only three internet-based companies run ads during the event. The bear market was made worse as accounting scandals of major corporations were exposed in late 2001 up to mid-2002. The market reached its trough in October 2002, with the Nasdaq printing values of circa 1,100, which represented a market capitalisation loss in excess of $5 trillion from the peaks of March 2000.
Many dotcom companies folded as venture capital dried up. Over 52% of companies did not make it past 2004. Those that survived had to make do with much lower valuations. Investors generally displayed caution in the markets, shifting their money to more established stocks. Major investment banks, such as Citigroup, were fined heavily by the US SEC (U.S. Securities and Exchange Commission) for misleading investors.
But it was not all doom and gloom for the tech sector. The tech sector in general consolidated and stabilised in the following years, and now major companies, such as Google and Amazon, are the most valued on Wall Street as of June 2021.
What Caused the Dotcom Bubble of 2000?
The dotcom bubble was caused by a combination of factors. A major reason was the overvaluation of the so-called dotcom companies. When valuing the companies, high multipliers were used as well as unreasonable metrics that ignored solid fundamental analysis. Important metrics, such as cash flow and profit generation, were deliberately ignored as analysts focused on unimportant issues, such as web traffic and possible future impact.
The media frenzy and the availability of easy capital also contributed to the dotcom bubble. An easy credit environment and favourable tax regime allowed investors to take aggressive speculative bets in the booming internet space. Any company or start-up with an internet-related business model literally had money knocking on its door. There was also no pressure to start generating money in the short term, with investors convinced that they were investing in ‘changing the world’. The lucrative nature of internet stocks was also exaggerated by the media, which made investors have unrealistic expectations of their investments.
The dotcom bubble highlighted important lessons that investors should take to avoid being caught up in such a crash. In particular, it is very vital to perform due diligence and proper research before placing your money on any stock. Instead of falling into the trap of investing in companies with the most buzz, investors should look at the underlying business fundamentals and the ability of the company to generate sustainable profits over the long run. During the dotcom bubble, it was common for companies that had no solid business models and were yet to show how they will generate cash flow, to access huge financial backing. The investors would later pay a heavy price for their recklessness during this period.
The important lesson is that business fundamentals must never be ignored. Investors should also be wary when investing in companies based on their future prospects. This also means that it is not prudent to invest in a space you do not understand well. Most of the investing activity during the dotcom bubble was purely speculative. Most investors did not understand computers well, let alone the internet, and they did not take any time to understand it. Their investing actions were largely emotional, with many of them just joining in for FOMO (fear of missing out). Most investors believed they were taking part in the ‘new economy’, but they did not understand how the companies would eventually leverage the internet to make money consistently. In the end, their ignorance was not bliss, with the market punishing them heavily.
Another lesson for investors is that during a market correction, it is overvalued stocks that suffer the most by overextending the decline. It was generally agreed at the time that almost all dotcom stocks were overvalued and had high beta coefficients (over 1). A company that has a beta coefficient of, say 0.5, will rise as much as 50% during a boom or collapse by as much as half during a crash. At the time, internet stocks had beta coefficients above 1; while this meant that they were lucrative during a boom, they also plunged heavily during the market correction or crash.
The dotcom bubble of 2000 is an illustration of how new technology is capable of generating hype that may quickly turn into a bubble. But while anything new is trendy and potentially a money-spinning opportunity, investors should invest with due diligence and never completely ignore the fundamentals. Furthermore, investors should appreciate that any high reward opportunity comes with a high risk attached. Thus, any new or trendy opportunity should be approached with the proper investing criteria applied to other forms of investments. Hype and buzz must never replace fundamentals and sound business models.