The Dot-Com Crash and Housing Bubble Explained
The bubbles from the sixties through the nineties were bad. But compared to what happened in the early 2000s, they were rehearsals.
When the internet bubble popped, over $8 trillion in market value vanished. Then the housing bubble nearly took down the entire world economy. Malkiel says comparing either of these to the tulip craze is unfair to the flowers.
The internet bubble
Every bubble starts with something real. The internet was a real technology with real business potential. The problem was what people did with that reality.
Robert Shiller describes it as a feedback loop. Internet stocks start rising. More people notice and buy in. Media covers the gains. Even more people buy in. Early investors brag at cocktail parties about how easy it is to get rich. Prices go higher. More buyers pile on. It’s basically a Ponzi scheme that works until you run out of new buyers.
The NASDAQ tripled from late 1998 to March 2000. Price-to-earnings ratios went past 100 for stocks that actually had earnings. Most didn’t.
Cisco was selling at a triple-digit earnings multiple with a $600 billion market cap. If it returned 15% per year for twenty-five years while the economy grew at 5%, Cisco alone would have been bigger than the entire U.S. economy. The math made no sense. Cisco still lost over 90% of its value when things fell apart.
The IPO frenzy
In the first quarter of 2000, 916 venture capital firms invested $15.7 billion in over a thousand internet startups. The companies that got funded were wild.
Digiscents wanted to make a device that made websites smell. Flooz offered an alternative currency you could email to friends. It went bankrupt after Russian and Filipino gangs bought $300,000 of its currency with stolen credit cards. And Pets.com, the one with the sock puppet mascot, learned the hard way that you can’t profit by individually shipping 25-pound bags of dog food.
Then there was theglobe.com. Two guys in their twenties who built an online message board in a Cornell dorm room. No revenue. No profit. Their IPO opened at $9 and shot to $97 on the first day. The company was suddenly worth a billion dollars. One of the founders was later caught on CNN dancing on a table at a New York nightclub saying, “Got the girl, got the money. Now I’m ready to live a disgusting, frivolous life.” The site shut down in 2001.
Companies were just adding “dot-com” to their names and watching their stock prices jump. Researchers from Purdue found that companies renaming themselves with web-sounding names saw prices rise 125% more than their peers in a ten-day window. Even when the company had nothing to do with the internet.
Analysts who knew better
Wall Street analysts were the cheerleaders pumping hot air into this balloon. Mary Meeker at Morgan Stanley. Henry Blodgett at Merrill Lynch. Jack Grubman at Salomon Smith Barney. They were celebrities earning millions.
Their pay was not based on the quality of their analysis. It was based on how much investment banking business they could bring in. The “Chinese Wall” between research and banking had turned into Swiss cheese.
Blodgett said traditional valuation metrics weren’t relevant in “the big-bang stage of an industry.” Meeker said it was “a time to be rationally reckless.” Ten stocks were rated “buy” for every one rated “sell.” During the bubble, the ratio hit a hundred to one.
New metrics replaced earnings. Analysts counted “eyeballs,” the number of people visiting a website. “Engaged shoppers” meant anyone who spent at least three minutes on a page. Nobody cared if they actually bought anything. Drugstore.com hit $67.50 during the bubble. A year later it was a penny stock.
“Mind share” was another favorite. Telecom analysts crawled into tunnels to count miles of fiber-optic cable in the ground, ignoring that only a tiny fraction was actually being used. Enough fiber was laid to circle the earth 1,500 times.
Fraud everywhere
The mania brought out the worst. Enron, the seventh-largest corporation in America, was the poster child. Wall Street loved it. Even as it started unraveling, sixteen of seventeen analysts covering it had “buy” ratings.
Behind the scenes, Enron was running elaborate scams. They set up partnerships with names like Cheruco (named after Chewbacca) and Jedi to hide losses off the books. They formed a joint venture with Blockbuster to rent movies online. The deal flopped, but Enron secretly set up a partnership with a Canadian bank, borrowed $115 million against future profits from the deal, and counted the loan as profit.
Enron’s executives even built a fake trading room to impress analysts. Employees called it “The Sting.” Phone lines were painted black to look slick. The whole thing was theater.
WorldCom overstated profits by $7 billion by classifying regular expenses as capital investments. As Malkiel puts it, some CEOs were really “chief embezzlement officers” and some CFOs were “corporate fraud officers.”
The housing bubble
If the internet crash wasn’t enough, the housing bubble was worse. For most Americans, their home is their biggest asset. When that goes down, everything goes down.
Banking had fundamentally changed. The old model was “originate and hold.” Banks made mortgage loans and kept them. If someone defaulted, the loan officer who approved it got questioned. This meant banks were careful.
The new model was “originate and distribute.” Banks made loans, held them for a few days, then sold them to investment bankers. Those bankers bundled the mortgages into securities, sliced them into tranches with different risk ratings, and sold them worldwide. Even low-quality loans could get AAA ratings on the top tranches.
Then came second-order derivatives. Credit-default swaps were sold as insurance on mortgage bonds. Companies like AIG sold these without adequate reserves. Anyone from anywhere could buy this insurance, even without owning the underlying bonds. The derivative markets grew to ten times the value of the actual bonds. The whole system became incredibly fragile.
Since banks didn’t keep the loans, they stopped caring who they lent to. NINJA loans became common. No income, no job, no assets. NODOC loans required zero documentation. Malkiel himself needed at least a 30% down payment for his first mortgage. Now people were buying homes with nothing down.
Home prices doubled in inflation-adjusted terms after being essentially flat for a hundred years. Then the bubble popped. Home prices dropped by about two-thirds on average. Homeowners found they owed more than their house was worth. Bankers called it “jingle mail” when people mailed their house keys back.
The financial institutions that had loaded up on these toxic mortgage securities started collapsing. Credit dried up. The recession that followed was the worst since the Great Depression.
So are markets inefficient?
After all this, you might think Malkiel would abandon the efficient market idea. He doesn’t.
His argument: the market corrected itself every time. Bubbles form, yes. But they always pop. True value always wins in the end. As Benjamin Graham wrote, the stock market is not a voting mechanism but a weighing mechanism. In the short term, popularity matters. In the long term, real value takes over.
The key takeaway is not that markets never make mistakes. They do, sometimes enormous ones. The point is that nobody can consistently predict when or how those mistakes will correct. Professional investors can’t reliably tell overvalued stocks from undervalued ones. As Malkiel puts it: no one person or institution consistently knows more than the market.
The consistent losers in investing are the people who get swept up in whatever the latest craze is. The internet. Housing. Whatever comes next. The lesson, chapter after chapter, is the same. Avoid the frenzy. Stay diversified. And remember that every bubble in history has eventually popped.
Previous: Wall Street Bubbles from the Sixties to the Nineties Next: Technical vs Fundamental Analysis: How the Pros Pick Stocks Part of the series: A Random Walk Down Wall Street Book by Burton G. Malkiel | ISBN: 978-0-393-08169-5