What is the 'Internet Bubble'

The internet bubble, also known as the dot-com bubble, which followed the invention of the world wide web in 1991, is a textbook example of a speculative bubble. The mania was part of a broader tech bubble that led to massive over-investment in telecoms and IT infrastructure, and the exponential growth and subsequent collapse in the Nasdaq index, the market for US technology stocks.

BREAKING DOWN 'Internet Bubble'

One of the features of the internet bubble 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.

Because 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.

Record amounts of capital flowed started flowing into the Nasdaq in 1997. By 1999, 39% of all venture capital investments were going to internet companies. That year 295 of the 457 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 would become the biggest merger failure in history.

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 the Greenspan-put was also blamed for the internet bubble.

Fed Chairman Alan Greenspan warned the markets about their irrational exuberance on December 5, 1996. But he did not tighten monetary policy until 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. Having poured gasoline on the fire, and Greenspan had no choice but to burst the bubble.

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 23 April 2015.

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