THEDOTCOMBOOMANDBUST

IDENTIFYINGTHECAUSESANDCHARACTERISTICS ST OFTHE21 CENTURYSFIRSTSPECULATIVEBUBBLE

NanaAburjanidze JenniferBoucher SarahNoall JoshuaParkinson SamuelZheng ProfessorMikeCooper FIN6360

TABLEOFCONTENTS
EXECUTIVESUMMARY........................................................................................................................................2 I.BUBBLES:CAUSESANDCHARACTERISTICS...........................................................................................................3 II.THEDOTCOMBUBBLE...................................................................................................................................4 III.IDENTIFYINGBUBBLESINREALTIME................................................................................................................7 IV.SUCCESSSTORIESINIDENTIFYINGTHEBUBBLE..................................................................................................9

 EXECUTIVESUMMARY
Inhis2000masterpieceIrrationalExuberance,RobertShillermadetheclaimthatstock markets were displaying the classic features of a speculative bubble: a situation in which temporarilyhighpricesaresustainedlargelybyinvestorsenthusiasmratherthanbyconsistent estimation of real value. i Shillers book appeared on store shelves in March 2000, the very peak of what would later be known as the Dotcom Bubble. During the 31 months that followed,theNASDAQlostnearly80%ofitsvalue,goingfromanintradayhighof5132.52on March10,2000toalowof1114.11onOctober9,2002. ii Over$7trillioninmarketvalueand thesavingsofmillionsofAmericanswerewipedout. iii HowhadShillermanagedtotimethereleaseofhisbook(aboutspeculativebubbles)at the very peak of the 21st centurys first speculative bubble? Had he experienced an incident similartoBernardBaruchsin1929,whenashoeshineboyofferedhimstocktipsandthereby revealedtheextentofthemarketsexcess? iv Notexactly.Shillerwrotehisbookandidentified theDotcomBubblebywayofspecificcriteriaandevidence.Thispaperwilldiscussanumber of these criteria and examine the evidence about speculative bubbles in general. Why do bubblesappearassuchonlyafterthefact?Isitpossibletoidentifytheminrealtime?Was anyoneelseabletoidentifytheDotcomBubbleinrealtime?Thesearethequestionswehope toaddressinthepagesthatfollow.

 I.BUBBLES:CAUSESANDCHARACTERISTICS
Economistsusethetermspeculativebubbletodescribeasituationwhereassetprices riseabovelevelsjustifiedbyeconomicfundamentals.Fundamentalvaluelevelsforassetscan bemeasuredinmultipleways.Oftentheyaremeasuredintermsofthediscountedfuturecash flows an asset may accrue. v However the fundamental valuation is computed, one thing is certain:assetspricesriseduringbubbles,anddosotothepointofbeingoverpriced.The prices then continue to rise further and further, far outstripping any realitybased valuation. Thisgoesonuntilsomeeventstymiesthebuying,andthenasteeppricedeclineensues. Economists and scholars from various disciplines have for years speculated about the causes of such runups in asset prices. These causes include but are not limited to: government regulation/deregulation, supportive monetary policy, new technologies, cultural changes favoring business, demographic changes, expansion of media reporting of business news,overoptimisticanalystforecasts,thegrowthofinvestmentvehicles(likemutualfunds), theperceiveddeclineofinflation,theexpansionoftradingvolumeviaretailtrading,andthe popularization of gambling. These factors combine with other amplification mechanisms like herdbehavior,overconfidence,andgeneralirrationalexuberanceaboutthefuturetoinduce andsupportassetpricerunups. vi Throughout theserunups, feedback mechanisms are at work. For example,investors are influenced by their own winnings and by tales of other investors winnings. Stories of windfallprofitsspreadthroughthemarketandenthusiasmincreases.AsStephenGreenspan putsitinhisbookAnnalsofGullibility,thefactthatso manypeopleareparticipatinginthe schememakesitappearsafeatthesametimethattheperceptionthatothersaregettingrich makesitappeartoogoodtopassup. vii Theseperceptionsencouragenew,lesssophisticated
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investorstoenterthemarketandbiduppricesevenfurther,creatingaselffulfillingprophecy of price rises. Soon the whole market becomes convinced that the old fundamentals of valuationnolongerapplyandthattheworldhasenteredanewera.Thefutureisconceived of as something fundamentally different from (and better than) the past. Overconfidence tightensitsgriponinvestorsandblindsthemtoanysemblanceofrealism.Prices,theinvestors claim(andbelieve),willnevergodownagain! viii Atthispoint,thefeedbackmechanismkicksin withevenmorethrustandthemediabeginsbroadcastingneweraclaimsinanattemptto explain and justify the excessive price movements. Shiller compares this phenomenon to a Ouija board, where players are encouraged to interpret the meaning of movements in their hands and to distill forecasts from them whilethey themselves movethe very Ouija pointer theyreinterpreting. ix Inotherwords,duringspeculativebubbles,investorsexplainpriceincreases(something they themselves cause) according to some objective, outside cause (something they dont cause):i.e.thenewera.Theinvestorsthenmakeforecastsbaseduponthatoutsidecause(the new era), and proceedto buy more assets in reaction to the forecasts. This perpetuates the price risesthe very phenomenon they were trying to explain in the first place and offers prooffortheobjective,outsidecause(thenewera)which,infact,theyhavecaused.Thisthen givesrisetofurtheroptimisticforecasts,andthepricespiralcontinuesupward.

II.THEDOTCOMBUBBLE
Looking back at the Dotcom Bubble, we seemany of the above causes at work. The runupinequitypricesduringthesecondhalfofthe1990sculminatedintheoneyeardoubling oftheNASDAQbetweenMarch1999andMarch2000.Thisentireperiodwasunderscoredbya seeminglyworldwideobsessionwiththecomingonsetofthenewmillennium.Y2K,asitwas known,wasnotjustacomputerbugtobeneutralized.Itwasalsoadatethatseducedmany investorsintothebeliefthatanewerawasuponthem. x Ofcourse,thisbeliefwouldlikely

never have taken hold were it not for the unprecedented advances in communication taking placeviathenascentWorldWideWeb. Asearlyas1998,theNASDAQwasalreadyrepletewithstartupinternetfirms,founded byentrepreneurs,fundedbyventurecapitalists,andbroughttomarketasIPOsbyinvestment bankers.Thehugecommercialpotentialthatinternettechnologyrepresentedreinforcedthe periodsnewerathemes.Internetenabledtechnologies,itwassaid,wouldrapidlychange the structure of the stock market, the corporate landscape, and the entire way business was done.Thismeantthatenormousopportunitiesawaitedthecompaniesthatcouldcreatenew innovativewaystosolveconsumerproblemsandprovidenovelproductsandservicesviathe internet. xi Shillerdescribestheunprecedentednatureofthenewinternettechnology: [Theinternet]iscomparableinimportancetothepersonalcomputeror,before that,thetelevision.Infact,theimpressionitconveysofachangedfutureiseven morevividthanthatproducedwhentelevisionsorpersonalcomputersentered thehome.Usingtheinternetgivespeopleasenseofmasteryoftheworld.They can electronically roam the world and accomplish tasks that would have been impossiblebefore.Theycanevenputupawebsiteandbecomeafactorinthe world economy themselves in previously unimaginable ways Because of the vivid and immediate personal impression the internet makes, people find it plausibletoassumethatitalsohasgreateconomicimportance. xii The rising economic importance of the internet, beginning in 1994, just happened to correspondchronologicallywithadramaticincreaseinUScorporateprofitsfromthatyearon. S&P Composite real earnings were up 36%, 8% and 10% in 1994, 95 and 96, respectively. Theseincreasesobviouslyhadnothingtodowiththeadventoftheinternet,butasthedecade wenton,correlationbegantobemistakenforcausationandthelinkingofhigherprofitswith theinternetandthenewerabecameevermoredeeplyentrenchedininvestorminds. xiii Byearly 2000, equity prices had spiraled out of control. Pricetoearnings ratios were higher than theyd ever been (and these ratios were for the companies that were actually profitable!).Manycompaniesthathadnevermadeadimeinprofitsweresellingatunheardof valuations. Alfred M. King, chairman of the board at Valuation Research Corp., wrote at the time: The new dotcom companies have no history, very low sales, and virtually no profitsyet they captured $900 billion in market capitalization. Skeptics have
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beenpredictingforyearsthatthebubblewillburst,but,sofar,ithasn't.Perhaps investorpsychologywillchange,andtheywon'tusetherationalethat"thisfirm could be the next Microsoft." Internet stocks would then be valued on a basis comparabletoFord,Texaco,andSearsallgreatcompanieswithalonghistory of sales and profits. But for the time being, investing in a basket of ebusiness companiesmaybesound. xiv Forthetimebeing,perhaps,butgrowthwithoutprofitabilitycouldnotbesustainedintheend, andinthespringof2000marketscapitulated.Asuddenwaveofsellingsentmarketsspiraling downward long enough and far enough to wipe out all investor optimism for the internet sector,andformostothersectorstoo.Thebubblethathadbeeninflatingforthepastsixyears suddenlypopped.Theaftermathwasnotpretty. xv ThenearbyFigure1illustratesthe39%fall intheNASDAQCompositeIndexduring2000alongwiththecontinuingdeclinesthrough2003. Figure2tracesthestockpricesoffivewebportalsoftheperiod,showingthedramaticcollapse inpricesbetweenMarch2000andJanuary2002.
Figure1

Figure2

Source:Yahoo!Finance

 Asfurtherevidencefortheseverityofthesituation,considerthefateofPets.com.The onlinepetsupplycompanymanagedtoraise$82.5millioninFebruary2000,andthenfailedto make it to the end of the year even with the support of Amazon.com, one of the few companies robust enough to withstand thecrash. eToys.com was another such casualty. Its shareswentfromahighof$84inOctober1999toalowofjust9centsinFebruary2001. xvi

III.IDENTIFYINGBUBBLESINREALTIME
Hindsightis20/20.Itseasytolookbackatspeculativebubblesandaffirmthemassuch expost.Lookingbackward,weseeboththefeatureswewereblindedtoduring thebubble, andtheeventsthatinevitablyfollowedtheburst.Forexample,lookingbackontheDotcom Bubble,wecannothelpbutnoticethenumerouscorporatescandalsthatsurfacedafterwardin 20012003. Historically, asset bubbles have tended to generate corruption, and the Dotcom Bubble was no different. Management at companies like Enron, Tyco, WorldCom, Adelphia, andParmalatusedthebubbletopursuetheirowninterestsbyinflatingcompanyshareprices. Lookingbackovertheperiod,manyinvestorsconvincethemselvesthattheymusthaveknown aboutthecorruptionallalong.Butidentifyingthecharacteristicsofspeculativebubblesinreal time is harder than it seems once one is looking back in hindsight. There are, nevertheless, methodsfordoingso. Themostobviousmethodforidentifyinganassetbubbleinrealtimeistocomparethe currentpricestobothhistoricalpricesandaveragehistoricalprices.Forexample,ifabuyerof tulipsduringtheDutchTulipManiaBubbleofthe1630shadsteppedbackandcomparedthe pricesofbulbsin1637tothepricesjustthreeyearsearlier,hewouldhavenoticedamorethan 100xincreaseinthepricesofsomebulbs. xvii Suchamultiplecouldbeinterpretedasasignof speculation.Again,thisiseasytosayinhindsight.Inthemomentathand,thespeculatoris likelythinkingthatahundredfoldincreaseinbulbpricesintherecentpastadumbratesasimilar

increaseinthenearfuture.Itthusprovesextremelydifficultwhenabubbleisunderwaytosell orstopbuyingattherighttime. Perhaps a better method for identifying an asset bubble in real time is to watch for grossdiscrepanciesbetweentheutilityoftheassetitselfandtheutilityofwhatitcanpurchase at its current price. For example, one Viceroy tulip in 1637 sold for the equivalent of $2 billiontoday: [During the height of the Tulip Mania,] the 2,500 guilders (currency) paid for a singlebulbwouldhaveboughttwentyseventonsofwheat,fiftytonsofrye,four fat oxen, eight fat pigs, twelve fat sheep, two hogsheads of wine, four tons of beer,twotonsofbutter,threetonsofcheese,abedwithlinen,awardrobeof clothes,andasilverbeaker. xviii xix Thatsalotofassetsfora3inchflowerbulb!Couldnttheownersorpotentialbuyersofsuch bulbsseeinrealtimethediscrepancybetweenthebulbsutilityandtheutilityofallthatgrain andlivestock?Again,thisiseasiersaidthandoneespeciallywhenoneconsidersthatabulb worth$2billiontodaymightbeworth$3billionnextweek,andthusbuy50%moregrainand livestockthanitcanbuytoday. Itturnsoutthatbothoftheaboveconditions(historicallyexorbitantpricesandlimited relative utility) were at play during the Dotcom Bubble. For example, when one compares equity prices during the bubble to historical equity prices, a major discrepancy becomes apparent. During the 105year period between 1900 and 2005, the average P/E ratio 1 for companies in the S&P 500 index registers somewhere in mid teens. xx In March 2000, at the peakoftheDotcomBubble,thataverageincreasedtoanalltimeintradayhighof47.2,nearly threetimesthehistoricalaverage.P/EsatthatlevelhadnotbeenseensinceSeptember1929, when the ratio hit 32.6. xxi Equities were clearly expensive by historical standards and any investor could have known this in real time. They also could have seen that the market capitalizationofmanyinternetstockswerehighenoughtopurchasefortunesincommodities, real estate, and other real assets. For example, online grocer WebVan.com, a company that

Thebestwaytocomparepricesofequitiesovertimeistousethepricetoearnings(P/E)ratio,whichmeasures howexpensiveacompanysstockisrelativetothecompanyscapacitytoearnprofits.Theratiocanbecomputed severalways,butthetenyearaverageisappropriateforusbecauseittendstosmoothoutthetemporarybursts andbustsinearningscausedbyanomalousevents.

never turned a profit, had a market cap of $1.2 billion at the height of the Dotcom Bubble. That capital could have purchased blocks of real estate in almost any American suburb, or shiploadsofcopperoroil.Lessthanayearafteritspeak,WebVan.comwasworthnothing.It ceasedtradinginJuly2001,makingits2,000employeesredundant. xxii

IV.SUCCESSSTORIESINIDENTIFYINGTHEBUBBLE
The question remains: who was actually able to identify the Dotcom Bubble in real time?Therewerecertainlyverbalwarningscomingfromthehighestechelonsofthebusiness world. For example, in September 1999, six months before the peak of the bubble, Steve Ballmer of Microsoft played the modernday Cassandra at the Society of American Business EditorsandWritersConferenceonTechnologyinSeattle.Hetoldreportersthatthere'ssuch anovervaluationoftechstocks,it'sabsurd,andthenaddedandI'dputourcompany'sstock inthatcategory. xxiii Ballmerswarningsobviouslywentunheeded.Themarketreadjustedonly slightly in reaction to his comments, and then resumed the charge upward. Investors continuedtopourtheirsavingsintotechstocks. ByMarch2000,anarticleintheWallStreetJournalwasacknowledgingthatinvestors were finding it difficult to justify the valuations of their tech stocks using traditional metrics. The article title referred to a new market order. xxiv Investment guru Warren Buffett commentedatthetimethathecouldnotrecognizeanytrulydurablecompetitiveadvantage theDotcomcompaniesheld. xxv ItisthusnotsurprisingthatBuffettrefusedtoparticipatein thepopulartrendofbettingonmultipleinternetcompaniesinhopesofpickingonethatwould eventuallymanifestacompetitiveadvantage. xxvi Inanycase,despitehisaccurateidentification of the nature of the Dotcom Bubble, Buffett did not profit significantly from either the expansionorburstingofthebubble.Infact,heapologizedtohisshareholdersin2000forhis companysmodeststockmarketperformancerelativetotherisingDotcomstars. xxvii Berkshire Hathawaydid,however,outperformtheNASDAQintheperiodbetween1996and2005witha geometricannualreturnof10.8%comparedtotheNASDAQs7.7%overtheperiod. xxviii
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Intheend,profitingfromtheupsideordownsideofaspeculativebubbleisextremely difficultbecauseitcallsformarkettiming"pickingtheexactmomentwhentobuyattroughs andsellatpeaks.Theproblemwithmarkettiming,asBuffetsays,isthatoftentheclockshave nohands. 2 Remarkably,thereweresomemutualfundsthatdidexhibitsignificantlypositive markettimingabilitiesduringtheDotcomBubble,especiallythoseintheaggressive,small company, and growth investment objective categories. However, the same studies which noticed the market timing abilities also showed that equityincome funds exhibit negative markettiming abilities, and balanced funds exhibit no timing abilities. xxix xxx Other studies havecometosimilarconclusions,indicatingthatgainsfrommarkettimingoverthelongrun requireforecastaccuraciesthatarelikelytobebeyondthereachofmostmanagers. xxxi PerhapsthemostremarkablecaseofaninvestoridentifyingtheDotcomBubbleinreal time was the case that began this paper in the Executive Summary. As mentioned above, RobertShillerwrotehisseminalworkIrrationalExuberanceintheyearleadinguptotheDot comBubblepeak,andthebookhitstoreshelvesattheverymonthofthepeak:March2000.In theprefacetothe2005editionofthebook,Shillerrelatesseveralinterestinganecdotesabout investorshemetduringthebooktourthatcommencedatthetipoftheMarch2000peak. I remember appearing on a radio talk show and hearing a woman tell me that shejustknewIwaswrong:thestockmarkethasapronounceduptrend;ithasto goupgenerally.Thetremorinhervoicemademewonderwhataccountedfor heremotions.Ialsorecallseeingamanwhocametotwoofmybooktalks,each timesittinginthebackandlookingagitated.Whydidhecomebackasecond time,andwhatwasupsettinghimso?...ButmostofwhatIrememberispeople cheerfullyandwithapparentinterestlisteningtomytalkandthenblithelytelling methattheydidnotparticularlybelieveme.Somekindofcollectiveconclusion had been reached about the stock marketand it had a powerful hold on peoplesminds. xxxii
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Thelineseparatinginvestmentandspeculation,whichisneverbrightandclear,becomesblurredstillfurther whenmostmarketparticipantshaverecentlyenjoyedtriumphs.Nothingsedatesrationalitylikelargedosesof effortlessmoney.Afteraheadyexperienceofthatkind,normallysensiblepeopledriftintobehaviorakintothatof Cinderellaattheball.Theyknowthatoverstayingthefestivities thatis,continuingtospeculateincompaniesthat havegiganticvaluationsrelativetothecashtheyarelikelytogenerateinthefuture willeventuallybringon pumpkinsandmice.Buttheyneverthelesshatetomissasingleminuteofwhatisonehelluvaparty.Therefore,the giddyparticipantsallplantoleavejustsecondsbeforemidnight.Theresaproblem,though:Theyaredancingina roominwhichtheclockshavenohands.Buffett,W.E.:"LettertoShareholders(2001).

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 Whatever the emotions of the investors Shiller encountered, Shiller himself seems to have succeeded at ignoring his emotions and noticing the writing on the wall. He observed that historically high price levels had been brought on by structural, cultural and psychological factors, including everything from new information technology to new era thinking to investoroverconfidenceandherdbehavior. xxxiii Shiller,ofcourse,isanacademicandnotan investmentadvisor,sohisinvestmentactivityduringtheperiodremainsamystery.Butifhe hadputhismoneywherehispenwas,andshortedthemarketatthetimeofhisbooksrelease, hesurelywouldhavemadeahandsomeprofit.
i

Shiller,Robert,IrrationalExuberance,2nded.(NewYork:Doubleday,2005),Preface:xx. http://en.wikipedia.org/wiki/Stock_market_downturn_of_2002(viewed:11/27/09).

ii

iii

Gray,KennethR.,LarryA.Frieder,andGeorgeW.ClarkJr."FinancialBubblesandBusinessScandalsinHistory." InternationalJournalofPublicAdministration.30.(2007):885.Print. iv http://money.cnn.com/magazines/fortune/fortune_archive/1996/04/15/211503/index.htm(viewed:11/26/09).

v

Lansing,KevinJ."AssetPriceBubbles."FRBSFEconomicLetter.2007.32(2007):13.Print. Shiller,Robert,IrrationalExuberance,2nded.(NewYork:Doubleday,2005),Ch.1. Lansing,KevinJ."AssetPriceBubbles."FRBSFEconomicLetter.2007.32(2007):13.Print. S.Greenspan,AnnalsofGullibility,1stedition,2009,Ch.8,pg.133

vi

vii

viii

ix

Shiller,Robert,IrrationalExuberance,2nded.(NewYork:Doubleday,2005),Ch.6.

Guttman,Robert."AssetBubbles,DebtDeflation,andGlobalInbalances."InternationalJournalofPolitical Economy.38.2(2009):5455.Print.

xi

Wheale,PeterRobertandAmin,LauraHeredia,BurstingtheDot.comBubble:ACaseStudyinInvestor Behaviour,TechnologyAnalysis&StrategicManagement,Vol.15,No.1,2003. Shiller,Robert,IrrationalExuberance,2nded.(NewYork:Doubleday,2005),Ch.3.

xii

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xiii

Ibid. King,Alfred,ValuingRedHotInternetStocks,StrategicFinance,81,10,2000,pp.2834.

xiv

xv

Wheale,PeterRobertandAmin,LauraHeredia,BurstingtheDot.comBubble:ACaseStudyinInvestor Behaviour,TechnologyAnalysis&StrategicManagement,Vol.15,No.1,2003. http://www.justsearching.co.uk/JustBlog/whydidthedotcombubbleburst.html(viewed:11/21/09). http://en.wikipedia.org/wiki/Tulip_bubble(viewed:11/27/09). http://www.pbs.org/thebotanyofdesire/(viewed:11/15/09)

xvi

xvii

xviii

xix

Chancellor,E.,DevilTaketheHindmost:AHistoryofFinancialSpeculation(FirstPlume,June2000)Ch.1.

xx

http://en.wikipedia.org/wiki/P/E_ratio Shiller,Robert,IrrationalExuberance,2nded.(NewYork:Doubleday,2005),Ch.1. http://www.justsearching.co.uk/JustBlog/whydidthedotcombubbleburst.html(viewed:11/21/09).

xxi

xxii

xxiii

McGee,Suzanne,SharePricesSufferLateDaySlideAfterWarningAboutTechSector.WallStreetJournal, (Easternedition),NewYork:Sep24,1999.p.C1.
Ip,Greg,WallStreetJournal,(Easternedition).NewYork:Mar13,2000.p.C1.

xxiv

xxv

Buffett,W.E.,"LettertoShareholders,BerkshireHathaway,March1,2000.

xxvi

Skapinker,Michael,Amadnessthatignorestheknownvirtues:Thedotcomboomislackinginrational scientificprocess,FinancialTimes,London(UK):Mar31,2000.p.05 Buffett,W.E.,"LettertoShareholders,BerkshireHathaway,March1,2000. http://finance.yahoo.com/

xxvii

xxviii

xxix

Bello,ZakriY.andJanjigian,Vahan,AReexaminationoftheMarketTimingandSecuritySelectionPerformance ofMutualFunds,FinancialAnalystsJournal,Vol.53,No.5(Sep/Oct1997),pp.2430.

xxx

Lee,ChengFewandRahman,Shafiqur,MarketTiming,Selectivity,andMutualFundPerformance:An EmpiricalInvestigation,TheJournalofBusiness,Vol.63,No.2(Apr1990),pp.261278.
Droms,WilliamG.,MarketTimingasanInvestmentPolicy,FinancialAnalystsJournal,Vol.45,No.1(Jan/Feb 1989),pp.7377. Shiller,Robert,IrrationalExuberance,2nded.(NewYork:Doubleday,2005),Preface. Ibid.

xxxi

xxxii

xxxiii

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