Impact On Financial Markets And Similarities With Techology Boom Of 2018

Introduction

The ‘Dot Com’ bubble is a period between 1995 to 2000 that was marked by rapid increase in stock value of internet companies due to excessive speculation. The period witnessed an extreme growth in the usage and adoption of the internet. During the bubble, the value of equity markets grew exponentially, with the technology dominated NASDAQ index rising from 1000 to more than 5000. However, with the turn of millennium, the values of these tech stocks took a nose dive when nearly a trillion dollars’ worth of stock evaporated in less than a month. The investment capital began to dry up, with many of the dot com companies filing for bankruptcy by the end of 2001.

Causes of the Dot Com Bubble

Various factors can be attributed to the creation of dot com bubble and its subsequent burst.

Growth in usage and adoption of internet

The decade of 90’s witnessed a phenomenal growth in the expansion and usage of internet. The price of personal computers had fallen within reach of common people and the world had started to witness the wonders of Internet connectivity. Focusing on the rapid adoption of internet and with confidence that the companies would turn huge profits in future, venture capitalists overlooked traditional financial metrics that measure a company’s health before investing.

IPO’s of companies without any demonstrated Success

Companies that yet to show any revenues, profits or even a finished product went public with Initial Public Offerings (IPO). Investment banks who profited significantly from IPO events, encourage investment in tech companies while fueling speculation. Looking to score big, large investors rushed in droves to buy the stocks with smaller investors following the bandwagon. As a result, stocks of such companies tripled and quadrupled in a matter of days.

Tax Payer Relief act of 1997

Tax Payer Relief Act of 1997 was a reduction in the capital gains tax rate, which made people more willing to make speculative investments in tech stocks.

Spending tendencies of Dot Com companies

Most dot com companies spent heavily on advertising and promotions in order to gain market share as fast as possible while incurring net operating losses, often providing their products for free or for large discounts in order to win large customers. In Jan 2000, 16 tech companies spent $2 million each for a 30sec commercial during the Super Bowl.

Low interest rates

Low interest rates by banks also fueled extensive borrowing by the tech companies to invest deeply in R&D as well as promotional activities.

Subsequent burst and its impact on the financial markets

By the start of 2000, the US Federal Reserve announced plans to aggressively raise interest rates which led to a significant increase stock markets volatility as analysts weren’t sure if increased borrowing costs would affect the fast growing tech companies. On March 15 2000, Yahoo and EBay ended the merger talks which caused the NASDAQ to fall sharply. In April of same year, Microsoft was declared guilty of monopolizing, as well as violating the Sherman Antitrust Act, which caused an 8% drop in the value of NASDAQ. The focus of investors went back to numbers rather than growth expectations. As a result, the venture capital funding, considered a life-blood for the tech companies, dried up. Without any subsequent revenues, many tech companies went out of business and folded their operations. High profile scandals like Enron, Worldwide and Adelphia further eroded investors trust. By the end of 2002, stocks had lost more than $5 trillion in market capitalization since the peak. During this period, a significant reduction in computer related jobs was witnessed and so was the enrollment in similar courses in universities.

The effect of DOT COM on 2008 crisis

It’s important to understand that within a single decade, the U.S market had to faced two financial market failures. However, it’s important to note that the effects of the Dot Com bust of 2000 trickled down and played a role in the 2008 financial crisis.After the dot com bust, the U.S Federal Reserve decided to lower the interest rate 11 times - from 6.5% in May 2000 to 1.75% in December 2001, in order to create liquidity in the market. This cheap money was very tempting for not only bankers, but also for the borrowers who had neither income nor assets. This access to money, along with the American dream of owning a home led to a frenzy in the housing market, resulted in a rapid appreciation in house prices. The low interest rates fueled a lot of uncollateralized lending. At the same time, bankers decided to repackage loans into collateralized debt obligations (CDOs) and pass on the debt to other investors. This led to the development of a big secondary market for the subprime loans. Regulators without fully understanding the consequences of their actions, played a role in the entire fiasco. The Securities Exchange Commission (SEC), in October 2004, relaxed the net capital requirement for five investment banks - Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns and Morgan Stanley. This led the firms to leverage themselves up to 40 times their investments. This significantly increased the exposure of these firms to risk, and when Lehman Brothers was not bailed out of its bankruptcy situation, the domino/contagion effect effected the global financial market.

How DOT COM was different from 2008

In comparison, the scale of both crises, in terms of value lost, was almost the same (around $5 trillion). However, the dot com bust resulted in a slight recession in the U.S economy, one that lasted 8 months, but the recession of 2008 lasted twice as long. We have tried to understand why that was the case. The collapse of the dot-com bubble led to the loss of value in stock prices. The investment mania brought on people who had the money to invest in paper-assets (stocks), whose value was known to rise and fall. After the dot com bust, investors in the equity market lost a lot of money, but there were no widespread bankruptcies on either the individual or the firm levels. However, during the financial crisis when the bubble was created by inflated house prices, the losses came in the form of bad debts. Banks and financial institutions were holding high risk mortgage-backed securities and faced huge losses when people were unable to pay their mortgages.

The main difference is that one included equity financing while the other involved debt. While equity is volatile based on what happens in the stock market, debt is independent of such market factors. Once borrowed, it must be paid back on schedule and failing to do so may lead to dire consequences. If we consider some similarities between the two crises, we see that both were a result of negligent investor speculation. The only difference was that during the 2008 crisis, investments in the housing sector continued to get complex by the introduction of derivatives such as CDO’s and CDS’s. This caused the contagion effect that spread from the U.S to the global financial markets.

Emerging technology bubble in 2018

Leading US companies such as Facebook, Amazon, Netflix and Google (FANG) together with Apple, Microsoft and some Chinese hottest technology companies such as Baidu, Alibaba and Tencent are boosting innovation behind internet of things, cloud storages, big data, e-commerce, artificial intelligence and machine learning. Like the dotcom bubble, there is a frenzy of technological innovation in market today. The NASDAQ composite has reached close to $8000 in 2018 (highest since conception) as compared to its peak of $5000 in 2000 before dotcom bubble burst. NASDAQ has started outperforming S&P 500 post 2008 crisis and gained momentum in 2016, like that of dotcom bubble (refer to Exhibit 2). These gains are mainly concentrated in technology companies indicating a formation of new technology bubble after dotcom crisis.

Although the prices of large technology stocks are up 400 percent in this decade as compared to 300 – 1900 percent rise during 1990’s and average price to earnings ratio is close to 20 vs 50 during 1990’s, yet the scale of today’s technology boom is not completely visible. The underlying reason is the focus of many new technology companies towards private equity market (venture capitalists or private equity funds) to raise the required capital. Venture capitalists have poured in more than $250 billion into technology sector since 2015. As a result, many “unicorn” companies have emerged whose valuation is close to $1 billion, before they have even gone public. If such companies failed to perform, then not only the private, but the public investors would lose trust in the technology sector and we might be seeing another technology bubble burst.

Moving forward

Many analysts believe that the growth of new technology companies is more sustainable as compared to 1990’s. However, there are three critical signals to watch for that might jeopardize this sustainability and result in the repetition of history.

First, the change in regulation against technology companies amid rising allegation of monopolistic behavior, breach of consumer privacy and productivity destruction (e.g. games termed as “electronic heroin”).

Second, the change in the monetary policy beyond current expectations such as that was carried out in 2000. Federal reserved increased the interest rate multiple time right before dotcom bubble crash, putting the technology companies in difficulty.

Third, unexpected fall in tech companies earning beyond analysts’ forecasts that would result in the loss of investor’s trust.