2000: STOCK EXCHANGE CRASH IN US

WHAT IS STOCK MARKET CRASH?

A stock market collapse is a sudden and unexpected decline in stock

prices. A stock market fall can occur as a result of a large disastrous

event, an economic crisis, or the bursting of a long-term speculative

bubble. Reactionary public fear in response to a stock market fall can

also be a key cause, prompting panic selling that further depresses

prices. Although no particular threshold exists for a stock market

crash, they are typically defined as a sudden double-digit percentage

decline in a stock index over a few days. Stock market collapses can

have a big economic impact.

CAUSES OF A STOCK MARKET CRASH

SPECULATION:

Many market collapses can be attributed to excessive speculation.

The 1929 Crash was a stock market speculative bubble in general.

The early-2000s tech stock crisis followed a period of excessive

investment in dot-com businesses. Furthermore, the 2008 crisis

might be related to investor speculation in real estate (and banks

enabling the practice).

EXCESSIVE LEVERAGE

When things are going well, leverage (sometimes known as

“borrowed money”) might appear to be a valuable instrument. For

example, buy 5,000 worth of stock and it climbs 20%, the buyer will

profit 1,000. If he borrowed 5,000 more and purchased 10,000 worth

of the same stock, he would make 2,000, doubling the gains.

Leverage, on the other hand, may be quite hazardous when things

are going against it. Assume if an identical 5,000 stock investment

plummeted by 50%. It would hurt but still have 2,500. If one borrows

a further 5,000, a 50% decline would have wiped him out. When

things go wrong, excessive leverage may cause downward spiral

inequities. As prices fall, businesses and investors with a lot of debt

are obliged to sell, which drives prices further lower.

RATES OF INFLATION:
Economically, higher interest rates indicate greater borrowing costs,

which tend to slow down purchasing activity, causing equities to fall.

As a result, if the 30-year mortgage rate rises to, say, 6%, it may

significantly halt the housing industry and cause homebuilder stocks

to fall.

POLITICAL ENVIRONMENT:

Markets like stability, but wars and political risk are the polar

opposite. When there is uncertainty in the surrounding the next

moves of the investors are spooked.

TAX CHANGES:

Deduction from the tax base of that portion of nominal income

resulting from inflation. The nominal taxable income remains

unchanged while the real taxable income falls with this technique. As

a result, it will compensate for the consequences of inflation.

These can be only a few of the huge reasons, but it is mostly a

combination of more than one factor.

WHAT WAS THE DOTCOM BUBBLE?

The dotcom bubble was a rapid rise in U.S. technology stock equity

valuations fueled by investments in Internet-based companies during

the bull market in the late 1990s. The value of equity markets grew

exponentially during this period, with the technology-dominated

Nasdaq index rising from under 1,000 to more than 5,000 between

the years 1995 and 2000. Things started to change in 2000, and the

bubble burst between 2001 and 2002 with equities entering a bear

market. The crash that followed saw the Nasdaq index, which rose

five-fold between 1995 and 2000, tumble from a peak of 5,048.62 on

March 10, 2000, to 1,139.90 on Oct. 4, 2002, a 76.81% fall. By the

end of 2001, most dotcom stocks went bust. Even the share prices of

blue-chip technology stocks like Cisco, Intel, and Oracle lost more

than 80% of their value. It would take 15 years for the Nasdaq to

regain its peak, which it did on April 24, 2015.

DOT-COM CRASH
The dot-com crash occurred in the NASDAQ starting in March 2000.

The tech index reached a peak of 5,048.62 on March 10, 2000. On

April 3, it fell 7.6% or 349.15 points. It fell 7.1% on April 12, 9.7% on

April 14, and 7.2% on April 18. It also had significant declines on May

30 (7.9%), October 13 (7.9%), and October 19 (7.8%). The worst crash

of the year was on December 5, when it fell 10.5%. On December 20,

it declined 7.1%. The NASDAQ ended the year at 2,470.52, losing

51.1% of its value from its peak.

The dot-com crash was caused by investors who created a bubble in

high-tech stock prices. They thought all tech companies were

guaranteed money makers. They didn't realize that tech's corporate

profits were caused by the Y2K scare. Companies bought new

computer systems to make sure their software would understand

the difference between 2000 and 1900. Back in those days, only two

date fields were needed and not the four required to differentiate

the two centuries.

After the 9/11 attacks, the markets closed for four days. When they

reopened on September 17, 2001, the Dow fell 685 points, a 7%

decline. The economy had entered the 2001 recession in March.

Threats of war kept the Dow down until 2002.

UNDERSTANDING THE DOTCOM BUBBLE

The dotcom bubble, also known as the Internet bubble, grew out of a

combination of the presence of speculative or fad-based investing,

the abundance of venture capital funding for startups, and the

failure of dotcoms to turn a profit. Investors poured money into

Internet startups during the 1990s hoping they would one day

become profitable. Many investors and venture capitalists

abandoned a cautious approach for fear of not being able to cash in

on the growing use of the Internet. With capital markets throwing

money at the sector, start-ups were in a race to quickly get big.

Companies without any proprietary technology abandoned fiscal

responsibility. They spent a fortune on marketing to establish brands

that would set them apart from the competition. Some start-ups
spent as much as 90% of their budget on advertising. Record

amounts of capital started flowing into the Nasdaq in 1997. By 1999,

39% of all venture capital investments were going to Internet

companies. That year, most of the 457 initial public offerings (IPOs)

were related to Internet companies, followed by 91 in the first

quarter of 2000 alone. The high-water mark was the AOL Time

Warner megamerger in January 2000, which became the biggest

merger failure in history. The bubble ultimately burst, leaving many

investors facing steep losses and several Internet companies going

bust. Companies that famously survived the bubble include Amazon,

eBay, and Priceline.

HOW THE DOTCOM BUBBLE BURST

The 1990s was a period of rapid technological advancement in many

areas. But it was the commercialization of the Internet that led to the

greatest expansion of capital growth the country ever saw. Although

high-tech standard-bearers, such as Intel, Cisco, and Oracle, were

driving organic growth in the technology sector, it was upstart

dotcom companies that fueled the stock market surge that began in

1995. The bubble that formed over the next five years was fed by

cheap money, easy capital, market overconfidence, and pure

speculation. Venture capitalists anxious to find the next big score

freely invested in any company with a “.com” after its name.

Valuations were based on earnings and profits that would not occur

for several years if the business model actually worked, and investors

were all too willing to overlook traditional fundamentals. Companies

that had yet to generate revenue, profits, and, in some cases, a

finished product, went to market with IPOs that saw their stock

prices triple and quadruple in one day, creating a feeding frenzy for

investors.

CHARACTERISTICS OF THE DOTCOM ERA

The frenzy of buying internet-based stocks was overwhelming, as

many internet-based companies, so-called dotcoms, were starting

up. Because they were in a fairly high-growth industry, they needed

funding. Funding came primarily from venture capitalist firms.

Lenders and individual investors also followed later. Instead of

focusing on the fundamental company analysis involving the study of

company revenue generation potential and business plans, industry

analysis, market trend analysis, and P/E ratio, many investors

focused on the wrong metrics such as traffic growth to their website

propelled by the startup companies. Most startups did not adopt

viable business models, such as cash flow generation; hence, they

were overvalued and highly speculative. It culminated in a bubble

that grew rapidly for several years. Outrageous valuations were

placed on these companies, and share prices continued to go up as

demand was overwhelming. Therefore, the bursting of the bubble

was inevitable and resulted in a market crash, which was more

conspicuous on the NASDAQ Stock Exchange.

The dotcom bubble crash was a shock event that resulted in massive

sell-offs of stocks, as demand waned and restrictions on venture

financing increased the rate of the downturn. The crash also resulted

in massive layoffs in the technology sector, as it was inevitable. The

dotcom bubble started collapsing in 1999, and the fall precipitated

from March 2000 until 2002. Several tech companies that conducted

an IPO during the era declared bankruptcy or were acquired by other

companies. Others hung by a thread as their stocks plunged to levels

so low it was never envisaged.

CAUSES OF THE DOTCOM CRASH

The cause of the dotcom bubble can be attributed to the following

factors:

1. OVERVALUATION OF DOTCOM COMPANIES

Most tech and internet companies that held IPOs during the dotcom

era were highly overvalued due to increasing demand and a lack of

solid valuation models. High multipliers were used on tech company

valuations, resulting in unrealistic values that were too optimistic.

Analysts did not focus on the fundamental analysis of these

businesses, and revenue generation capability was overlooked, as

the focus was on website traffic metrics without value addition.

Research carried out revealed an overvaluation of more than 40% of

dotcom companies by studying their P/E ratios.

2. ABUNDANCE OF VENTURE CAPITAL

Money pouring into tech and internet company start-ups by venture

capitalists and other investors was one of the major causes of the

dotcom bubble. In addition, cheap funds obtainable through very

low interest rates made capital easily accessible. It coupled with

fewer barriers to acquiring funding for internet companies led to

massive investment in the sector, which expanded the bubble even

further.

3. MEDIA FRENZY

Media companies encouraged people to invest in risky tech stocks by

peddling overly optimistic expectations on future returns and the

“get big fast” mantra. Business publications – such as The Wall Street

Journal, Forbes, Bloomberg, and many investment analysis

publications – spurred demand through their media outlets adding

fuel to a burning fire and further inflating the bubble. Alan

Greenspan’s speech on “irrational exuberance” in December 1996

also set off the momentum on technological growth and buoyancy.

HOW TO AVOID ANOTHER BUBBLE

The measures below provide some insights on how to avoid another

internet bubble:

1. PROPER DUE DILIGENCE

Investment in new start-ups and similar tech companies should only

be considered after carrying out proper due diligence, which involves

a closer look at the company’s fundamental drivers of value, such as

cash flow generation and sound business models. The long-term

potential of a stock should be properly analyzed, as a short-term

focus will lead to the formation of another bubble.

2. REMOVING “INVESTMENT OF EXPECTATION”

Investors should desist from investments based on unrealized

potential in entities that are yet to prove their cash flow generating

ability and overall long-term sustainability. The expectations lead to

the emergence of a bubble through speculation.

3. AVOIDING COMPANIES WITH A HIGH BETA COEFFICIENT

During the dot-com bubble, most tech stocks posted high beta

(greater than 1), meaning their downfall in times of recession would

be much more than what the average market fall would be. A high

beta coefficient signals a high-risk stock in times of a market

downturn. Since the opposite is true when there is a market boom,

investors should be wary of a bubble formation.

A CASE STUDY

OVERVIEW

This case study examines the Dot-com Bubble during the late-1990s

and early-2000 from the perspective of an analyst/trader that utilizes

fundamental, quantitative, technical, and intermarket analyses. The

Internet Boom starts with the founding of Netscape in 1994, whose

eponymous browser revolutionalizes access to the Web. By the time

AOL acquires it for $10 billion in March 1999, the equity market is in

a feeding frenzy as fundamental metrics are cast aside and Wall

Street Internet analysts become household names. Like most

financial market bubbles, the burst sends shockwaves across the

globe as so-called experts, regulators, politicians, and media wonder

how such a thing could have happened. An examination of factors

reveal that the signs of an impending burst are all there for the

objective investor/trader whose emotions are held in check.

THIS TIME IT’S DIFFERENT

To justify the ginormous valuations of New Economy stocks, Wall

Street analysts parrot that equity markets have entered a new

paradigm: “This time it’s different!” By 2001, the price-to-earnings

ratio of the Nasdaq-100 rises to above 100. Jumping on the band

wagon, mainstream businesses begin attaching Dot-com pieces to

drive the S&P 500 PER to 45. Succumbing to Internet hysteria,

fundamentals are binned as newly IPO’d companies, some with zero

profits and minimal revenues, routinely jump 100% on first day

trading.
DAY TRADING

Ironically, the growth of the Internet and access to the Web

introduces day trading of stocks to anyone with computer and a dial-

up connection to the Internet. While traditional sentiment indicators,

like Investors Intelligence Advisory Reports and Put/Call Ratio, give

loud bearish contrarian signals, the rising number of day traders,

some of whom have quit their 9-to-5 jobs, surely shouts “bubble.”

Ultimately, euphoric emotion and greed drive Internet stocks to their

dizzying heights and as rationality returns, fear takes over and the

fall from grace is severe. To a lesser extent, the general market also

enters bubble territory during the heady 1990s.

DOW THEORY

Dow Theory practitioners receive two signals in the late-1990s that

Old Economy stocks are due for a major correction. Shaking off the

remnants of the late-1980s S&L Crisis, the Dow Jones Industrial

Average climbs throughout the 1990s to all-time highs. Then, in mid-

April 1998 the Dow Jones Transportation Average fails to confirm

new highs of the DJIA at 9172: Signal 1 (first dotted line in Chart 2).

Sure enough, the DJIA falls 19% from mid-July to end of August. Yet,

buoyed by ever-rising Internet stocks and announced technology

acquisitions, the DJIA regains its legs to not only recover, but rise to

new record highs; by May 1999 the DJIA stands at over 11000. Once

again, the DJT does not confirm DJIA: Signal 2 (second dotted line in
Chart 2). The DJIA continues its parabolic rise until mid-January 2000

when the euphoria subsides (ellipse in Chart 2); DJIA meanders

lower, dropping 31% by September 2001. Dow Theory warning

signals arrive well-ahead of the Dot-com Bubble burst.

BEARISH DIVERGENCE OF SMALL CAP STOCKS

After a prolonged upturn, small cap stocks tend to peak ahead of the

general market as smaller companies’ access to capital dries up first.

From the early-1990s, the Russell 2000 small caps rise along with the

S&P 500. The first sign that all is not well arrives in mid-April 1997

when a bearish divergence develops as the Russell 2000 fails to

confirm the rise in the S&P 500 (first dotted line in Chart 3). From

mid-July to end of August, the S&P 500 collapses 18%. But, stocks
recover to new record highs until a second bearish divergence forms

from early-March 2000 (second dotted line in Chart 3). The S&P 500

finally succumbs in early-September as professional traders return

from summer vacation (ellipse in Chart 3). Again, technology

investors receive ample warning of rising risk, this time from small

cap stocks.

THE GREENSPAN PUT

Liquidity acts as the lifeblood for most financial bubbles. For the Dot-

com Bubble, the Greenspan Put, or the tendency for Fed Chairman

Greenspan to lower interest rates, loosen monetary policy, and/or

talk the market higher when stock prices begin to fall, essentially

gives investors a free put option, placing a floor on stock prices. Even
after his December 1996 “irrational exuberance” speech (dotted

vertical line in Chart 4), the Fed lowers target Fed Funds Rate three

times in 1998, propelling New Economy stock skyward. Note how six

increases in target Fed Funds Rate in 1999 have no effect on the

parabolic rise of Dot-com stocks. Eventually, New Economy stocks

reach their final apex in March 2000 (ellipse in Chart 4). As stocks

start to slide, the Fed, as though attempting to revive a cardiac arrest

patient, lowers target Fed Funds Rate eleven times in 2001. But, to

no avail, the Nasdaq Composite ultimately collapses 72% by

September 2001 as fear takes over the market. From peak to trough,

over $5 trillion is wiped out of share holdings in Nasdaq Composite

companies (March 2000 to October 2002).

LESSONS

Euphoric emotions and greed drive financial bubbles; retail and

professional investors, Wall Street analysts, regulators, politicians,

and media can succumb to investing mania. Fundamental factors of

financial assets (e.g. PER, PSR,PEBITDAR, ROA, ROC) generally move

within in a given trading range. When stocks trade at fundamental

factors excessively above historical range, this acts as a warning

signal that the probability of a correction is rising. Likewise, Dow

Theory and small cap stock performance can indicate increased

chance of a correction. Finally, financial bubbles tend to be liquidity-

driven events, thus focus on the actions of monetary authorities, not

on their rhetoric, on whether liquidity is being increased or

decreased. Nevertheless, rising interest rates have significantly

smaller effect on New Economy stocks than on capex, debt-heavy

Old Economy stocks.

LESSONS LEARNED FROM THE DOT-COM CRASH

Just over a decade ago, the future of the World Wide Web held

tremendous potential to transform commerce, communication and

the workplace as we know it. Dot-com innovators and investors were

trying to keep pace with our forward thinking—until the crash of

2001 brought everything to a screeching halt.

Now in 2013, a second high-tech surge is upon us, fueled partially by

the growing adoption of cloud services, accompanying mobile

technologies and, last but not least, the social media revolution. The

Dow Jones Industrial Average and the S&P 500 are at or near historic

highs and the NASDAQ has delivered consistent growth. Companies

like Apple, Facebook and Google are leading this charge, driving new

wealth as they continue to grow and pouring dollars into their local,

national and international economies.

There’s no doubt we’re on the verge of what is perhaps the most

monumental tech boom to date—one even greater than the birth of

the Internet. This begs the question: what lessons can we learn from

the dot-com boom and the crash that followed?

When we look back at the dot-com area, it’s easy to see that

buzzwords like “eCommerce” and even “the Internet” were

conceptual. Investors hungered to be part of this innovation and

invention, and quickly threw money into anything that seemed

capable of turning a profit. In 1999, there were 457 IPOs and over
25% doubled in stock prices. But within two years, the infamous dot-

com crash erased much of that progress. The number of IPOs

plummeted to just 76. Many of the most promising companies filed

for bankruptcy including [Link], WorldCom and [Link].

While this boom and crash was unfortunate for investors, it actually

produced some of the most innovative ideas that were simply just

ahead of their time. Concepts developed by many companies that

went under, including VoIP, eCommerce, big data and the web

experience, still live on today, in many cases as the fundamental

concepts driving success in large corporations. In our current

euphoric high-tech state, investors are paying millions of dollars to

acquire under-the-radar companies. Large enterprises are snatching

up the companies behind the core technologies they need to power

their own path to success. But, amid the app-building, VC frenzy, it’s

critical that we remain mindful of a few fundamental differences

between today’s tech environment and the dot-com era. Certainly

our economy cannot bear another crash. After two years, we have
yet to fully recover from the sub-prime mortgage and financial

crisis—another downward spiral may be catastrophic.

To that end, I believe several key factors will keep the current high

tech environment a bit more grounded and realistic than the bubble

we experienced over a decade ago. First, the Internet has evolved

from the futuristic concept it was in the 90s into a real business

productivity tool, enabling new technologies like Voice over Internet

Protocol, Software as a Service and Infrastructure as a Service to

emerge as invaluable IT assets for companies of all sizes. The

accessibility and ease of building a business based entirely on the

Internet has led to the emergence of hundreds of startups, fostering

a continuous high-tech buzz. Second, our investors have learned a

lesson or two from the dot-com crash. A decade ago, it was typical to

invest in innovation alone, whereas now, a working business model

and a plan for cash flow must be in place. Today’s investors look for

scalability, monetization and future product development roadmaps

before making a decision. Even larger companies in acquisition mode

have similar requirements. Lastly the Consumerization of

Information Technology (IT), the BYOD phenomenon, is having a

huge impact on high-tech’s second surge. This entirely new concept

following the dot-com crash is motivating the entire high-tech

industry to invent new and better technologies that are more

accessible and make the workplace easier and more efficient. As

common consumer technologies make their way into the workplace,

major players looking to add security and cloud solutions to their

portfolio are acquiring businesses and startups that provide these

solutions. The reality is, many businesses are successful because they

are either using consumer tech in the workplace, or because they are

producing it. This megatrend means that high-tech is in high

demand, and this will not change any time soon. Being part of high-

tech’s rebirth is like being part of the Internet Renaissance. Having

survived the dot-com crash, we’re now able to collectively harness

that experience to take business technology to the next level.

Investors and entrepreneurs should continue to introduce

innovations that will ultimately shape our future. Just like the

Internet Renaissance was once a distant concept, the ideas

entrepreneurs are formulating now will soon become commonplace.

With these lessons learned and the continued innovation emerging

from both startups and large corporations alike, I believe we’re on

the cusp of high-tech’s greatest days.

BIBLIOGRAPHY

INTERNET

[Link]

[Link]

[Link]

[Link]

[Link]

[Link]