Internet Bubble Research Paper

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A bubble is an unsustainable increase in the price of an asset type driven by the expectation of further price increases rather than fundamental characteristics. Bubbles are a concern of social science since they result from individual calculations about the behavior of others in society.

Indeed, in his 1721 poem about the first price escalation for which the term bubble was widely used, Jonathan Swift linked the British South Sea Bubble to the “madness of the crowd” denying the fundamentals: “But as a Guinnea will not pass / At Market for a Farthing more / Shewn through a multiplying Glass / Than what it allways did before” (1958, p. 255).

During a bubble, the downplaying of fundamental analysis leaves little to counterbalance the momentum of the rising price and the solidifying of interests in its preservation. Lower-quality assets rise along with higherquality assets when fundamental characteristics are less distinguished. As suggested by John Stuart Mill in Principles of Political Economy (1848), assessing price becomes even more difficult when money is borrowed: “Some accident, which excites expectations of rising prices … a generally reckless and adventurous feeling prevails, which disposes people to give as well as take credit more largely than at other times, and give it to persons not entitled to it” (1899, p. 47). The most vexing feature of a bubble was captured by Alan Greenspan, the chairman of the Federal Reserve Board, when he testified in April 2000 at a Senate Banking Committee hearing that a bubble cannot be definitively identified until after the fact. The benefit of hindsight suggests that there was an Internet stock bubble as Greenspan spoke.

The Internet Bubble was set against the backdrop of rapid growth in Internet use. The 1991 invention of the World Wide Web and the 1994 release of the Netscape browser transformed a text interface into a more accessible graphical interface that propelled Internet use from about 10 percent of Americans in 1995 to 50 percent by 2000. This growth held the promise of making money and a boom of investment capital flowed into Internet enterprises, commonly referred to as “dot.coms.”

One way to generate investment dollars was by issuing stock in an Internet-related company. Upon issue, Internet stocks often experienced a dramatic rise in price. Multifold increases in price on the day of issue were common. The success of early Internet stock issues prompted additional offerings. Prices for Internet stocks continued to soar in the late 1990s.

The broad expectation of increasing Internet stock prices reduced concern for the fundamental characteristics of the individual companies whose stock price was increasing. Many of the dot.coms had never made a profit. Companies operated under the assumption that if they could generate a sizable user base by giving away their product or Web site content, they would eventually figure out how to make money. Traditional standards of longevity and profitability before issuing a stock gave way in a climate of high valuations for even fundamentally weak business models. The number of potential stock buyers increased with the advent of online trading in which the Internet itself reduced transaction costs for buying stocks. Many stock buyers were encouraged to borrow based on expected price increases. Investment clubs and day traders proliferated. The expectation of rising prices was strong, but not sustainable. Lacking strength in the fundamentals, Internet stocks could not avoid the ultimate spiral downward when owners began selling to take profits and later to reduce losses.

The significant presence of Internet-related companies on the Nasdaq Stock Market makes it an appropriate place for identifying the contours of the Internet Bubble. Nasdaq closing values reveal a thirty-month period in which the composite index tripled and then returned. The Nasdaq closed at 1639.19 on October 20, 1998, reached 3000 for the first time on November 3, 1999, and peaked at 5048.62 on March 10, 2000. On the decline, it had closed below 3000 by November 13, 2000, and was at 1638.80 on April 4, 2001. The deflated bubble left Internet stock values at a tiny percentage of their highs and dotted the landscape with failed companies.

The massive shift of wealth during the Internet Bubble produced winners and losers. A variety of advantages, including access to the initial offering price and reserved shares, meant that those on the inside of stock offerings were more likely to be winners than were ordinary buyers. One clear winner was Internet innovation, which was facilitated by the large amounts of capital that went to enterprises during the Internet Bubble.

Bibliography:

  1. Ip, Greg, Susan Pulliam, Scott Thurm, and Ruth Simon. 2000. The Color Green: The Internet Bubble Broke Records, Rules and Bank Accounts; Wall Street and Allies Built $1.4 Trillion Monument to Fast-Money Madness. Wall Street Journal, July 14.
  2. Mill, John Stuart. 1899. Principles of Political Economy with Some of Their Applications to Social Philosophy. Vol. 2. New York: Colonial Press. (Orig. pub. 1848).
  3. Swift, Jonathan. 1958. The Bubble. In The Poems of Jonathan Swift. Vol. 1, ed. Harold Williams. London: Oxford University Press. (Orig. pub. 1721).

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