04. The Explosive Bubbles of the Early 2000s

Dated Jun 1, 2019; last modified on Mon, 04 Oct 2021

Dotcom crash took away $8tn (yearly output of Germany, France, England, Italy, Spain, the Netherlands, and Russia) of market value.

The Internet Bubble

The internet had 2 bubble qualities: some new technology & some new business opportunity.

A Broad-Scale High-Tech Bubble

Cisco and JDS Uniphase, producers of the backbone of the Internet, sold at +100 P/E.

As usual, companies changed their names to include “dot.com”, “dotnet”, and “Internet”.

Stock High ‘00 Low ‘01–‘02 Decline
Amazon.com 75.25 5.51 98.7%
Cisco Systems 82.00 11.04 86.5%
JDS Uniphase 297.34 2.24 99.5%
Priceline.com 165.00 1.80 99.4%
Yahoo.com 238.00 8.02 96.4%

PalmPilot (maker of PDAs) was at one point valued at 2x its parent company, 3Com.

Yet Another New-Issue Craze

A computer peripheral that would make websites and computer games smell. Flooz.com: A currency that could be e-mailed ($800 for $1000 Flooz cash) Pets.com: Shipping low-margin 25-pound bags of kibble.

Security Analysts $peak Up

Analysts from Morgan Stanley, Merill Lynch and Salomon Smith Barney fueled tech stocks.

Analysts were the very public cheerleaders for the boom! Traditionally buy:sell ratings for stocks was 10:1; it was now 100:1.

Investment banks take a laissez faire approach to underwriting, e.g. *the public doesn’t like dual-class stock, but we won’t stop you - Snap even sold zero-vote shares (bloomberg.com, 2017/01) . Goldman used to require 3 years of profitability, but FOMO in the dotcom boom made them scrap that rule. (bloomberg.com, 2020/01)

New Valuation Metrics

To value Internet companies, eyeballs (# visitors) and mind-share (% of online time in a given space) were used.

For telecom companies, length of fiber-optic cables in the ground (as opposed to the tiny % that had traffic) was used.

The Writes of the Media

Investment magazines: Internet stocks likely to double in the months ahead.

CNBC and Bloomberg became cultural phenomena.

There were 10m Internet “day traders”, many of whom had quit their jobs. Most actually lost money even during the bubble.

Fraud Slithers In and Strangles the Market

Enron made complex partnerships that facilitated overstatement of Enron’s earnings, e.g. counting loans as profits.

Telecoms overstated revenues through swaps of fiber-optic capacity at inflated prices, and masqueraded expenses as revenue.

Should We Have Known the Dangers?

The key to investing is not how much an industry will affect society or even how much it will grow, but rather its ability to make and sustain profits.

The US Housing Bubble and Crash of the Early 2000s

The New System of Banking

Old system: banks hold mortgage loans until they’re repaid.

New system: banks make mortgage loans; holds them for a few days (low risk thus minimal due diligence); sells them to investment banker; i-banker issues bonds “securitized” by the interest and principal of underlying mortgages.

The mortgage-backed bonds were sliced into different tranches: AAA-bonds had first claims on payments from underlying mortgages. The “AAA” rating was used even when underlying mortage loans were low quality.

Credit-default swaps (2nd order derivatives!) were issued as insurance policies on the mortgage-backed bonds. Owning an underlying bond was not required to buy the swaps. Swaps traded to as much as 10x the underlying bonds’ value.

Looser Lending Standards

No equity down for mortgage loans in the hopes that housing prices would rise forever.

Federal Housing Administration was directed to guarantee the mortgages of low-income borrowers.

The Housing Bubble

Easy credit pushed up house prices rapidly. Positive feedback loop.

Home buyers discover mortage » home value; they start defaulting.

House prices drop. Mortgage-backed securities plummet.

Bubbles and Economic Activity

It’s not that the market is inefficient, but that it corrects itself slowly and inexorably.

Investment risk is never clearly perceived. The discount rate is never certain. Markets are not always or even usually correct, but no one consistently knows how.

The Bubble in Cryptocurrencies

I think I’m more knowledgeable than Malkiel in technical crypto matters. Let’s see if he holds up.

The entire cryptocurrency market is relatively small, but the increase in prices was dramatic. 2017 BTC: $750 -> $20,000 -> $14,000.

Bitcoin and Blockchain

Malkiel oversimplifies stuff, e.g. “A coded and password-protected (but anonymous) entry on the ledger records ownership of the bitcoin."

As long as the BTC does not fluctuate in value during the short period in which the transaction takes place, the dollar value does not matter.

Not really, if the reward BTC is not worth more than my mining costs, then I won’t mine it. Or maybe I’ll still mine it and hope that it appreciates in the future?

Jamie Dimon: BTC is a worthless fraud. Howard Marks and Buffet: Cryptocurrencies are not real and have no value.

I think he changed his mind later. On one hand, maybe you do have to be special to be JPMorgan’s CEO, but on the other hand, corporate-speak and conflict of interest?

What is the definition of money?

  1. A Medium of exchange.
  2. A unit of account to post prices and record debts now and in the future.
  3. A store of value.

BTC’s extreme volatility makes it fail #2 and #3. At least for major currencies, there’s a central bank that prevents volatility.

Should the Bitcoin Phenomenon Be Called a Bubble?

The blockchain technology is real, and could catch on.

This is a common argument by the ‘enlightened’ crowd. But blockchain looks like the ‘dotcom’ of our day. Sometimes what companies need are (SQL) databases and access controls. The blockchain saga is for gullible investors.

Bubbles are propagated by popular culture: Pitbull, Katy Perry, Paris Hilton, Floyd Mayweather, Lionel Messi, Grey’s Anatomy, Big Bang Theory, The Good Wife, The Simpsons.

Wait, Messi? You were the chosen one!

“Long Island Iced Tea Corp” => “Long Blockchain Corp”; stock surges 289%. Glance Technologies: buy weed… with cryptocurrencies.

What Can Make the Bitcoin Bubble Deflate?

Governments can:

  • Ban usage of BTC, e.g. Roosevelt banned holding gold in 1933.
  • Shut down crypto exchanges.

If BTC “whales” decide to start cashing in.

If the encryption system gets broken.

At this point though, BTC would be the least of our problems.