What Is the Internet Bubble?

The internet bubble was a speculative bubble that developed following the popularization of the world wide web in 1991. The mania was part of a broader tech bubble that led to massive over-investment in telecoms and IT infrastructure. This investment rush led to exponential growth and a subsequent collapse in the Nasdaq, the market for US technology stocks.

Key Takeaways

  • The internet bubble was largely the result of a new, poorly understood commercial opportunity presented by the popularization of the world wide web.
  • Many investors, including institutional investors, were uncertain on how to value new companies with business models built on online activities.
  • The eventual popping of the internet bubble was heavily influenced by the actions of the Federal Reserve and Alan Greenspan in particular.

Understanding the Internet Bubble

One of the features of the internet bubble of the 1990s was investors’ suspension of disbelief about the viability of many dot-com business models. In this New Economy, a company needed only to have a “.com” in their name to see their stock prices skyrocket following an initial public offering (IPO), even if they had yet to make a profit, produce any positive cash flow, or even produce any revenue.

Venture capitalists, investment banks, and brokerage houses were accused of hyping dot-com shares so they could cash in on the wave of IPOs, but Federal Reserve monetary policy was the underlying driver for the internet bubble. The Greenspan Fed aggressively lowered interest rates through the late 1980s and early 1990s pushing a wave of liquidity into capital markets that initiated the boom in tech.

The Greenspan-put that developed during this era was also to blame: in 1994-1995 Greenspan lobbied hard for the Mexican peso bailout, and in 1998 the Fed bailed out Long Term Capital Management. This led tech investors to expect that regardless of underlying fundamentals, the Fed would in turn bail them out too if the internet bubble were to burst.

Because it was believed that traditional valuation methods could not be applied to internet stocks with new business models and negative earnings and cash flow, investors put a premium on growth, market share, and network effects. With investors focusing on valuation metrics like price-to-sales, many internet firms resorted to aggressive accounting to inflate revenue.

With capital markets throwing money at the sector, start-ups were in a race to get big fast. Companies without any proprietary technology abandoned fiscal responsibility and spent a fortune on marketing to establish brands that would differentiate themselves from the competition. Some start-ups spent as much as 90% of their budget on advertising.

The Peak of the Internet Bubble

Record amounts of capital started flowing into the Nasdaq in 1997. By 1999, 39% of all venture capital investments were going to internet companies, and near 295 of the 457 IPOs that year were related to internet companies, followed by 91 in the first quarter of 2000 alone. The AOL Time Warner megamerger in January 2000, is regarded as the peak of this bubble, which would become the biggest merger failure in history. At the very peak of the bubble, Greenspan famously doubled down on his belief that the internet bubble was sustainable and that the tech sector, along with Fed policy under his leadership, had fundamentally transformed the economy to permanently increase productivity.

The Internet Bubble Bursts

Early in the growth of the bubble, Fed Chair Alan Greenspan warned the markets about their irrational exuberance on Dec. 5, 1996. Finally, by the spring of 2000, after banks and brokerages had used the excess liquidity the Fed created in advance of the Y2K bug to fund internet stocks, the Fed had begun to mildly raise rates based on inflationary imbalances building in the economy. Having poured gasoline on the fire, Greenspan now tried to damp the inflationary flames, and in the face of slower monetary expansion, the bubble immediately burst.

The crash that followed saw the Nasdaq index, which had risen fivefold 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 dot-com stocks had gone 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 dot-com peak, which it did on April 23, 2015.