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The Stock Market Bubbles
With reference to the previous sections, it can be
seen that there are many potential forces, which could influence the
valuation of the dotcom stock market and hype up the price of the market.
Looking at the NASDAQ index (see graph below), it can
be seen that it has increased tremendously between the years of 1996 and
the beginning of the year 2000. It may be hard to justify that such an
increase is economically justified and from this point onward the stock
market has halved in value until today. When a stock market index performs
like this, it is considered to be a so-called stock market bubble.
In order to justify this, we will first explain the
term stock market bubble in detail and then look at historic bubbles and
compare them with the NASDAQ, establishing any similarities.
The term bubble is used to describe a stock market
that is trading at a price above its rational value, which can be
determined by its long-term performance. During the period when the share
prices are rising, this is considered the growing stage of the bubble. As
the bubble expands, the evaluation of the companies in the stock market
also follows suit. At this stage, there is much assurance in the market
and this is often exaggerated, which brings about the over-valued
companies.
In due course, there comes a stage when the
assessment of the bubble is found to be inaccurate and the predictions of
the performance of the dotcom are over estimated. This results in a harsh
fall in the share price and the bubble is said to have burst.
A classic example of a bubble is the Tulip Bubble.
This issue occurred in Holland in the seventeenth century.
The introduction of tulips in Holland brought about a lot
excitement amongst the wealthy as it was an expensive product. It was
considered a luxury item. It became popular very rapidly and the demand
for tulips increased dramatically. Eventually, the demand exceeded the
supply of tulips. This in effect caused a substantial rise in the price of
a tulip.
People who grew tulips were highly positioned in the
market and they made large profits by selling the tulips for very high
prices. Other began to see the profits reap in for the tulip planters and
they too wanted to grow tulips. The limiting factor was the amount of
tulip bulbs available. As a result, not many new entrants into the tulip
market emerged. So, the price of tulips carried on increasing steadily for
another two years.
In the third year, the value of tulips was so large
that people used to trade in tulips, and each day the value of the tulip
would be higher. One day a merchant can exchange a tulip for one good. The
next day, the value of the tulip would be worth two goods instead! People
gained instant wealth from all this and they soon began to trade tulips
when the value was up.
Eventually, investors could not see the value of
tulips increasing much more in the long run. This speculation led to a
frantic market where everyone was trying to sell off his or her tulips. As
expected, the value of the tulip dropped and so did its price. Within just
days, the price had plummeted so low that investors who hadn’t managed
to sell their tulips off had made huge losses and were suffering financial
difficulties as a result. The Tulip Bubble burst.
It can be concluded that there are many similarities
between the Tulip bubble and the dotcom market. Especially the limited
number of tulip bulbs can be compared to the limited number of shares
released by the VCs.
The Comestock Lode Silver Rush took place in the beginning of
the nineteenth century. This bubble was not in the same ‘game’ as the
Tulip bubble. Instead the bubble can be referred to as an ‘insider
versus outsider’ situation. The investor was the victim and the mine
owners were the ones who reaped the most profits. The investors had to
rely on the mine owners for the statistics of amount of silver left in the
mines. However, since the mine owners also had shares in the market, they
led the investors to believe that there was more silver in the mine than
in reality.
The result was an increase in share price and when the mine owners
believed that the price what as it maximum than they sold their shares.
When the information spread that the mines were depleted the market
crashed and the bubble burst.
In today’s dotcom market these kinds of frauds still persist, as
it is very difficult for the investor to differentiate between true
information and lies. These companies are without a proper business plan
and they lack any economic performance (P/E ratio).
A huge ‘bubble’ was the Great Wall Street Crash
in 1929. Years before this crash, the share prices were increasing
constantly. Many people began to make great profits and as a result people
invested in all kind of different companies. It did not matter which
company or in which market the investment was made. The money invested
always returned in an increased format. An increasing desire to prosper
and cultivate their profits. This is a desire is a characteristic that is
always present in a “bubble” market.
Even famous economists at the time were as caught up
in the speculations as the rest of the people. A good example of this is
an analysis that an economist, Irving Fisher of Yale University, did. He said: “Stock prices have reached what looks like a permanently
high plateau”.
Eventually, as always in a bubble market, people
finally realised that the stock market was highly overvalued and soon they
began selling off their shares. The “bubble” burst and the price on
all stocks plunged to a small fraction of what the price had been before.
It took only a few days for the bubble to burst. This
shows that there is an enormous amount of speculation involved in the way
that investors are evaluating a market. This is an enormous influence and
it can change the direction of the share price within days. If traditional
analysing had been done, all the people who invested in the stock market
would not have been as badly affected by the fluctuations in share price.
As with all other bubbles the burst left all the
investors in economical misery. It has to be realised that in a bubble
market, mainly the people who enter the stock market last are the biggest
losers. These people were caught up in all the rumours about instant
wealth that were circulating the market before it burst and they invested
in stocks without knowing anything about the companies they were investing
in. It also has to be realised that there are a few winners in a bubble
market. These are the people who invested in the beginning of the up-going
trend and who sold their shares before the bubble burst. Were these people
just lucky? This is probably the case for some of the people but a
reasonable guess it that a higher proportion of these were insiders. They
knew more or less what was going on and they managed to use the situation
in an advantageous way for themselves.
The dotcom bubble also shows the phenomena of having
mobilised a huge amount of investors, which were willing to put their
fortunes into the market without analysing the market themselves. What is
the reason for this? The answer is simple greed and opportunism that
develops among people is situations like this.
We shall consider first the
technological changes that took place over the last century, and the p-e
ratio of America’s S&P 500 relating to the changes.
The first huge P/E ratio fluctuation was observed in
1929 in the Wall Street Crash, where shares tumbled by 80% over the next
three years and the same happened when the railway and car were first
introduced. Often, a wave of new technology has been followed by the rise
and later, the fall of share prices.
There are many similarities between the recent
Internet boom and the oil crisis that occurred in 1980. Many newly formed
dotcom companies nowadays are not much different from the bubbly companies
of the past. Most of them have no clear defined strategy as they had been
counting on the public markets and venture capitalists to subsidize them
until they somehow obtain enough customers to make money, before they go
bust. In reality, less than 10% of the dot.com companies would survive
through this fallout just like the railway mania, 99% of the 5000 railway
companies that once existed in America are no longer around. The same goes
for 2000 car firms.
Although the share of profits often rises during the
early stage of technology-led expansion, as it did in the 1990s, it then
usually declines as a result of competition from new entrants who are
attracted by high returns.
With the technology revolutions, the development of
instant communication would create a virtual marketplace where consumers
could quickly compare prices and drive down the margin levels. The
long-term winner will end up being the consumers who gain from lower
prices and hence higher real wages. The overvaluation of the dotcom
companies can be explained by the example below.
Consider National Gift-Wrap and Box, a traditional
company that sells boxes and bags to retailers. The company itself grows
approximately 6%-7% a year, which is lower than the average S&P 500 of
10%. Let’s say the average company sells at 20 times earnings, investors
would pay some fraction of that 20 multiple for National Gifts earnings.
You wouldn’t pay more because of the slow growth but you wouldn’t want
to pay nothing because it is growing and generates a return, so National
Gift wrap would have a lower multiple than most of the S&P 500.
Now let’s consider NationalGiftWrap.com, another
division of the main company. The company runs a business-to-business web
site allowing retailers to go online nation-wide and buy boxes and bags
cheaply. Initially the company made no money, so it didn’t have a
multiple. It was all about potential. In the first year, it made $5million
in revenue and contacted an investment banker about going public listed.
The company told the banker that it might be able to make $30m in revenue,
and that it would not be surprise if it could triple revenue in the 3rd
year because the market is growing so rapidly.
As the market was growing so rapidly, it would not be
unusual for NationalGiftWrap.com to be valued high, if not higher than the
traditional company even though one is profitable and slow growing while
the other is extremely unprofitable and fast growing. This happened
because the market presumed that National Gift Wrap.com would be far more
valuable in the “outer years” than it’s parents. Instead of valuing
these companies on their potential growth, investors had begun to evaluate
them on their potential profitability.
Returning to the dot.com example, lets say in the 2nd
year, National Gift Wrap.com which is a $2billion company with no
multiple-to-earnings, earns $28million in revenue instead of the target of
$30million, investors wouldn’t like that and the market would simply
take the stock apart. Companies these days have to show great revenue and
near term profitability. This is what the dot.com companies are now
facing; a rapid growth followed by a fierce competition result in
price-cut for their service. With the price cut however, companies will
still need to show investors that, with every quarter, they are getting
closer to making money. A vast number of dotcom companies, which have
failed to do this, have been punished as a consequence. The biggest IPO
losers this year was Pets.com who are currently trading at $0.06 compare
with the first day close of $11, their share value have dropped 99.98%.
The above serves to give an overview of the entire
dotcom industry and a taste of the market sentiments in the so-called
“bubble markets”. Yet, to get a more precise idea, some well known
individual dotcom companies will be looked into in the subsequent
sections.
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