Case Study: Dot-com Bubble

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, technical, quantitative, 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 technical, intermarket, and fundamental 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.

CS 2000 Dot-com Bubble Chart 1
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.

CS 2000 Dot-com Bubble Chart 2
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.

CS 2000 Dot-com Bubble Chart 3
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.

CS 2000 Dot-com Bubble Chart 4
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).

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 affect on New Economy stocks than on capex, debt-heavy Old Economy stocks.


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