From Dot-Com to Dot-Bomb

Anyone reading this blog will most likely either have been sat in Professor John Turners lecture last week, or will in fact be John Turner, and so you should be aware that there are main 3 causes of asset bubbles. Just in case someone who isn’t from the risk management class has stumbled upon this blog and wasn’t in the class, the 3 causes put forward in the lecture were:

1) Agency costs associated with borrowed money
2) Technological Revolutions
3) Investor-Deceiving Frauds

In class I came to the conclusion that there was no single cause for a bubble, but rather it is usually a mixture that contributes. Of the reasons above, the technological revolution jumps out as the obvious answer to the cause of this bubble. The rapid uptake in use of the internet was seen by many as being the start of a “new era”, and this mentality will certainly have contributed to the growth of the bubble. However, another theory I would suggest is that it might have been a form of Investor-Deceiving Fraud.

Hickson and Turner (2006) argued that governments might be responsible for bubbles because of a threat of imminent revolution, or because of a diminished concern for the middle class. It is the second theory here that I think should be considered.

The Private Securities Legislation Reform Act (1995) was designed to restrict the ease with which lawsuits could be brought against firms over claims about performance. The problem this Act created is that it is very difficult to actually prove a company is making an over-hyped statement, and so in effect, this Act may have encouraged firms to make outlandish statements as they were protected from potential litigation. The growing prevalence of the internet made it very easy to hype up stock prices, and with the protection of the PSLRA, many firms did exactly this.

One of the many casualties of the
dot-com bubble bursting

I don’t really think that the government was deliberately trying to defraud investors, or encourage the growth of the dot-com bubble. I do believe, however, that the actions taken by the government in the run up to the dot-com bubble may well have contributed to the growth and size of the bubble.

More Dot-Com Failures

My last post looked at the failure of Flooz.com which raised and lost approximately $35m in its 2 year existence. This was however a relatively small failure in the dot-com era, and there were many other spectacular failures in the run up to the dot-com bubble bust.

For those readers who are interested in reading more about some of the biggest failures of the time, there is a really interesting list you can read at cnet.com which profiles 10 of the greatest failures of the dot-com bubble.

I also found a great info-graphic produced by GDS Infographics on Flickr that provides an excellent graphical representation of the scale of some of these failures. And here is a final image that sums up the boom and bust of the dot-com bubble.

Flooz.com

One of the most fascinating stories from what I have read on the dot-com bubble is that of Flooz.com. This was a company that was set up with the premise of providing an “online currency” that would act as an alternative to paying for things online with your credit card. You had to buy Flooz from their website, or you could receive them as a kind of gift token from other internet companies, and then you were able to use it at retail partners that had signed up, including some notable firms such as Tower Records and Barnes & Noble.  The company even had the public backing of Whoopi Goldberg (a signal of potential success?) and it is estimated the company raised approximately $35million from investors.

One example of how Flooz tried to attract users was an offer where you could give someone $50 in Flooz and receive $15 yourself, which is an offer that will have clearly appealed to many people. However, for something like this to work it would obviously need to become a widely used medium of exchange.

It didn’t.

Flooz went bankrupt in 2001, leaving many people with Flooz that were now worthless. One point that I should make about Flooz.com and its failure is that, as stated by its founder Robert Levitan, by mid-2001 approximately 19% of purchases of Flooz could be accounted for as fraudulent purchases. This may have accelerated its decline, but its fair to say that, “the writing was on the wall” regardless. 

The question I keep asking myself when I read about Flooz.com is why did anyone invest in it? Maybe hindsight makes this idea look so ridiculous, but why would anyone want to buy an “online currency” when they could just use the currency they already have? For the company to have raised so much money though, it must have struck some people as a good idea. Or maybe, people didn’t really think about what it was they were investing in, and they simply jumped on the bandwagon of another internet start-up with big ambitions, but one, like so many others, without a real sense of how to achieve those lofty ambitions. 

A message from Osama Bin Laden, circa 2000

Money For Nothing

This graph tracks the growth of internet users,
which started to explode in the mid-90's 

Despite the title, some readers might be disappointed to know this post has nothing to do with the Dire Straits (Although there probably is a play on words here to do with the dot-com bubble). The mid-1990’s saw the number of internet users grow exponentially and this was seen by many companies, and entrepreneurs, as a large pool of potential profit-generating individuals. Firms promised customers and investors that this was the beginning of a “new world”. Internet start-ups started appearing everywhere you could look, with many engaging in new and untried business models to try and capitalise on the potential within the market.

Many firms went for a, “growth first, profit later” approach, with the belief that if they could capitalise on a particular niche in a market, they could then make profit once their customer base was established. There are sensible and non-sensible ways to grow quickly though, and many didn’t adopt particularly sensible practices. For example, some companies undercharged for the shipping on items, taking huge losses in order to try and gain market dominance.

These dot-com companies were funded by over-zealous investors who were giving cash to companies who didn’t know what to do with it, because at the time internet start-ups were seen as being the future, and everyone wanted a piece of the action. Reality set in on March 10^th 2001 however, with the Nasdaq Composite Index peaking at 5,132.52 and then falling dramatically.

The bursting of the dot-com bubble wiped out billions of dollars in market value. With the market falling around them, many dot-com companies fell too, but not before burning through what remained of the venture capital they had raised. Like previous bubbles, the value of the dot-com companies fell from their ridiculously high values pre-crash, in an event that could have been predicted by market traders. But this bubble, like so many others, was punctuated by greed with too many people chasing easy money without considering their actions, or the events of the past.

What is an Economic Bubble?

Professor Charles Kindleberger, from the Massachusetts Institute of Technology, defined a bubble in the New Palgrave: A Dictionary of Economics as:

“A bubble may be defined loosely as a sharp rise in the price of an asset or a range of assets in a continuous process, with the initial rise generating expectations of further rises and attracting new buyers – generally speculators interested in profits from trading in the asset rather than its use of earnings capacity.” (Eatwell et al, 1987)

What Kindleberger is implying with this definition is that asset bubbles are created when assets are valued higher than what they are intrinsically worth. 

A warning pamphlet printed by the Dutch
government, warning of the dangers of
investing in Tulips

There have been many examples of such asset price bubbles, with the first real being the “Tulipmania” of the 1630’s when the price of tulip bulbs reached astronomic levels, with some estimating that prices reached approximately 10 times the annual wage of a skilled worker. Tulips were seen as the “sure-thing investment” of the day, and this confidence that they would always make an investor money lead to a severe case of hubris in the market. Then, in February 1637 it was considered that tulips weren't as valuable as their price indicated, and from February to May 1637 bulbs which were once very valuable became basically worthless. Other notable asset bubbles since Tulipmania have included the South Sea Bubble of 1720, “Railway Mania” in the 1840’s and the Great Crash of 1929.

The Dot-Com bubble was caused mainly by excess speculation on internet start-up companies, which saw stock markets grow very quickly for approximately 5 years, from 1995-2000. The boom and bust of the dot-com bubble draws very clear parallels with many previous asset bubbles throughout history. Clearly lessons were not learned from these bubbles though, as history went on to repeat itself during this bubble. Over the next few posts I will consider what happened during the dot-com bubble and what happened when it burst?