The new age high tech generation may seem to be immune to market inefficiencies of the past. They may seem to be aware of the true value of everything because of the vast network of information that they are connected to. However, this did not stop them from falling prey to the folly of an asset bubble. In fact, at the turn of the century when internet and related technology really took off, it ended up creating a massive bubble in almost no time. This bubble went bust in 2001 and is popularly known as the “dot com” bubble.

The dot com bubble wiped out many overly ambitious startup companies out of existence. It also impacted the giants like Microsoft and Cisco. The real reason behind the dot com bubble burst was that it had become a bubble in the first place! The dot com companies were worth adding a lot of value and were worth a lot of money. However, economic forces had driven the valuations to unsustainably high levels and a crash was inevitable. In this article we will cover the story of the rise and fall of the dot com companies.

The Fed Drops Interest Rates

The internet business was already making waves. Many companies related to information technology had grown from garage startups to economic powerhouses. However, these companies were few and far off. By and large investors were judging the companies based on their business model and there was no mania which was distorting the way investors looked at companies.

All this changed when the Fed dropped the interest rates to historic lows. The idea behind this was to fend off the deflationary impact of the Y2K bubbles. Whenever, Fed drops interest rates, the money supply increases. During the early 2000’s the money supply was increasing at the rate of 22%. All this new money was being pumped into the economy. This money was looking for a new home and dot com companies seemed to be the most efficient way to utilize this money at that time.

Hence, like many other bubbles, the foundation of the dot com bubble too was laid by the very agency which is supposed to be preventing asset bubbles i.e. the Fed.

Irrational Business Models

A lot of dot com companies had futuristic business models. Some of them were visionary while the others were outright irrational. Either ways, the projected cash flows of these dot com companies were expected to come after a few years. Hence, at any given moment, there was no way to distinguish between a visionary and an irrational model. Also, given the excess cash that was present in the system, venture capitalists did not bother differentiating. They just offered cash to any dot com company!

Irrational Compensations

The unrealistic plans of the dot come companies could also be gauged from their human resource plans. A lot of these companies were offering staggering compensation to relatively young executives with almost no track records. Executives in their mid twenties were being appointed as chief officers. When the compensation was tied to stock price increases, there was a smaller problem. However, when the compensation was given out in cash, it caused a problem. Companies that were not earning a dime in their operations were paying some of the most outrageous and big ticket salaries to their executives. The irrational compensation models were basically supported by the excess money that was flowing in from the venture capitalists to these companies.

Irrational Valuations

The final stage of the dot com mania was reached when any company that had dot com in its name would derive an immediate benefit. This prompted companies to add .com to their names even though their business models had little to do with the internet. The market capitalizations and valuations would skyrocket overnight by mere change of name. Investors were not even concerned about the underlying business model. They were just willing to an additional premium to anyone who was remotely connected to the web. Large companies had to change their business models to accommodate the internet in order to remain relevant in the market.

The Fed Raises Interest Rates

The party finally came to an end, when the Fed raised interest rates sharply. The Fed was forced to do so in order to rein in inflation. However, the effects were catastrophic. Money supply in the system fell down drastically. As a result, investors had to pull out investments suddenly. Given that most of their investments were in illiquid tech companies, liquidation meant a severe loss of value. Falling stock prices created panic amongst investors and the gloom and doom prediction became a self fulfilling prophecy. The tech companies that seemed to be the future of the economy suddenly started to look like irrational investments. Venture capitalists tried desperately to sell their stake in the companies. When they could not, many simply resorted to shutting down companies causing fear and job loss across the economy and aggravating the crisis.

Thus, the Fed’s inflationary and deflationary policies can be considered to be the real cause of the bubble. Technology stocks just happened to be the preferred home of the excess capital that was first released into the system and later sucked out from it.