Lessons from the dotcom

When you hear the term “dotcom”, you probably think about websites you find on the internet. For most people over the age of 30, the term dotcom will bring up memories of the period when the internet was the hot new topic in the late 1990s. Many businesses were keen on starting a new chapter with the turn of the millennium and leveraging all of the wonders the internet would bring. But, it didn’t really pan out as planned. Here’s what happened.

What was the ‘Dotcom’ era?

The onset of the new internet economy, by and large, fully unlocked the limits once placed on our imagination; in short, anything ‘seemed’ possible. This was the ‘vision’ that these new and highly-speculative internet-based companies – which showed little to no potential for profitability – were selling to investors.

As the ‘internet era’ broadened people’s imaginations, the value of these so-called dotcom companies increased as their share prices soared amid a buying frenzy. Essentially, FOMO kicked-in, and investors and speculators demand resulted risingshare prices of these growth-orientated technology stocks. Their shares were priced at unsustainable levels, which analysts found increasingly difficult to justify based on business fundamentals.

Sharemarket bubbles and the dotcom pop

In a sharemarket ‘bubble’, speculation and even euphoria can take over with investor behaviour overriding company fundamentals. A sharemarket ‘bubble’ is considered a run-up in share prices without a corresponding increase in the value of the company.

While it can be argued that the sharemarket contains a certain degree of speculation, in a sharemarket ‘bubble’, this level of speculation is heightened to the point where investors turn a blind eye to, or ignore, basic company fundamentals. Investors continue to bid stock prices higher, without realising that the value of the company itself hasn’t increased by a corresponding amount.

Equity analysts and portfolio managers will often argue that a company’s valuation should be determined by fundamentals, such as the company profits, earnings, the quality of the management team as well as growth profile of the industry in which it operates.  

In the late 1990s, the line between ‘investment’ and ‘speculation’ blurred, the ‘bubble’ grew and investors continued to buy stocks of companies that had obvious red flags. Naturally, some of these companies eventually went out of business. When investors truly realised the ‘irrationality’ of their behaviour, many sold their holdings, pushing down the share prices of these tech companies. This led to the ‘bubble’ popping  – a whopping 56.3 per cent fall in the tech-heavy US Nasdaq index in the year to March 2001.

But not every surge in a tech company’s share prices is considered a ‘bubble’. Amazon is a classic example of a company that has seen its share price soar well over 1,600 per cent in the past decade. But, importantly, the company’s earnings have kept pace with the share price, growing as its competitive advantage in the online marketplace strengthened.

So, it begs the question; Have the recent falls in the share price of tech stocks in late 2021 and early 2022 been evidence of just another ‘popping’ of the ‘bubble’?

History repeating?

A careful look at some data might indicate some interesting similarities between now and the dotcom era.

In the dotcom period; that is, over the (approximate) five year period from January 1995 to March 2000, the Nasdaq index – a tech-heavy index which consists of stocks listed on the Nasdaq exchange - soared 524.6 per cent (Source: Refinitiv, CommSec). The Nasdaq index then fell 54 per cent in the year to March 2001 (Source: Refinitiv, CommSec).

More recently, the tech-heavy Nasdaq index surged 144.5 per cent in the year and a half from its lows on March 23, 2020 to its highs on November 22, 2021 (Source: Refinitiv, CommSec). And since the start of the new year through to March, the Nasdaq fell by around 15 per cent (Source: Refinitiv, CommSec).  

So, how do the two periods compare? Well, high valuations was the main driver of risk for tech companies during the dotcom era. Now however, tech household names like Apple, Amazon, Netflix and Tesla not only bear the risk of a high valuations, but are also exposed to a confluence of ‘other issues’. These issues include geopolitical tensions, and the impacts of the Covid-19 pandemic health crisis, which revolve around multi-decade high inflation rates, supply chain issues and semiconductor shortages. Interestingly, rising interest rates was also a thematic during the dotcom era. From February 2000 to May 2000, the then US Federal Reserve Chairman Alan Greenspan increased the Federal Funds Rate from 5.75 per cent to 6.5 per cent.

Rising interest rates have also been in focus recently with inflation rates at 40-year highs due to supply-demand imbalances during the pandemic. And the Ukraine war and supply restraint from OPEC producers have recently seen crude oil prices hit 14-year highs.

But, while parallels between the 1990s dotcom and 2021/2022 pandemic periods can be drawn, it’s important to note that tech companies’ performances didn’t match investors’ expectations back in the late 1990s. Companies went bankrupt, others saw their growth slow markedly and profits fail to materialise, pushing down share prices sharply.

However, movements in the tech sector now are markedly different to those seen in the dotcom era. Price movements recently have so far implied that markets have ‘corrected’ (another way of saying that markets have run up too high, and are now ‘normalising’) as opposed to how markets ‘crashed’ in the dotcom era. Since its November 2021 highs to mid-March, the Nasdaq index has shed around 22.4 per cent (Source: Refinitiv, CommSec), which is less than the 56 per cent ‘crash’ in the Nasdaq exchange seen in 2001.

The 2020-2022 COVID-19 pandemic has caused unprecedented demand for the goods and services of some tech companies, pushing up their earnings as investors sought growth and yield during a period of record low interest rates and unprecedented policy stimulus. This is very different to the dotcom ‘start-up’ period when venture capitalists were throwing money at nascent tech companies with a speculative eye on the future. 

Diversify, Diversify, Diversify

So, while some parallels between the two periods can be drawn, ultimately the circumstances are different. From an investor perspective, ‘bubbles’ are difficult to avoid and even trickier to time. A useful starting point to navigate these ‘bubbles’ would be to consider the lessons learnt from the dotcom era, and how investors can better position their portfolios. 

How? Simple but crucial: don’t put all your eggs in one basket.

As an investor, it’s important to spread your risk over a number of different investments so that if a certain investment or asset class was to underperform, the losses as a percentage of your whole portfolio will be smaller. But just as losses can be minimised from the view of the whole portfolio, it’s also important to remember that gains from individual investments will also be diminished.

You can diversify across asset classes by purchasing bonds, real estate, commodities or currencies, or within equities themselves by selecting investments in different industries, sectors or countries.

As a recent example, people that were invested in the technology sector may have been able to offset their losses if they held investments in the energy sector.

Trust research, not the hype

It’s quite common for sentiment to drive prices in the short term. In the long run however, prices are usually dictated by the fundamental strength of the company, which can be determined through research.

If investors do due diligence on companies, they may be able to avoid purchasing shares of highly speculative companies that are trading at extremely high valuations.

So, the rule before you purchase a stock: know exactly what’s driving you to purchase it. Do your research such as - what the company does, its risks, its growth drivers and its earnings potential.

Still working out your own way to invest. Get some inspiration from Hayley.