The Dot-com Bubble 1995–2002

What you will learn

• The timeline and index levels of the dot-com boom and bust in the United States and Germany.
• Why a correct story about a new technology can still lead to very poor investment returns.
• How to calculate the earnings growth that a high price-to-earnings ratio requires.
• Which warning signs of 1999–2000 can be checked in any market.

Explanation

The boom

The internet was a real change in how the economy works. From the mid-1990s, investors rushed into companies that promised to benefit from it. In December 1996, Federal Reserve chairman Alan Greenspan asked publicly how one could know when "irrational exuberance" had raised asset values too far; prices kept rising for more than three years. Many newly listed companies had small revenues and no profits. Analysts used new measures such as website visitors ("eyeballs") instead of earnings. Telecom companies borrowed heavily to build networks far beyond actual demand.

The Nasdaq Composite, an index dominated by technology companies, reached 5,048.62 points on 10 March 2000. By widely cited estimates its price-to-earnings ratio was far above 100 at the peak. The price-to-earnings ratio (P/E) is the share price divided by earnings per share (EPS); valuation multiples are explained in the Stock Analysis course. Here we use P/E to ask what the price assumes about the future.

The bust

The Federal Reserve raised interest rates in 1999 and 2000. Companies without profits ran out of cash and could not raise more. The Nasdaq fell to 1,114.11 in October 2002, a loss of about 78%. Accounting frauds at Enron (bankrupt in 2001) and WorldCom (2002) damaged trust further and led to the US Sarbanes-Oxley Act of 2002, which tightened rules for company accounts. The Nasdaq only closed above its 2000 peak on 23 April 2015, about 15 years later in price terms. Even some strong survivors took many years: Microsoft's share price was still about one-third below its 2000 peak in 2015.

Germany: Neuer Markt and the "T-Aktie"

Deutsche Börse opened the Neuer Markt, a segment for young growth companies, on 10 March 1997. Its NEMAX 50 index peaked at 9,666 points on 10 March 2000 and later fell to a few hundred points, a loss of more than 90%. Several listed companies were found to have reported false figures, for example ComROAD, which invented revenue. The segment closed on 5 June 2003.

Deutsche Telekom went public on 18 November 1996 at DM 28.50 (about €14.57), and 1.9 million Germans bought shares, about a third of them for the first time. Further offerings followed in 1999 at €39.50 and in 2000 at €66.50; the share reached €103.50 at its peak and then fell far below all offering prices. In 2014 Germany's Federal Court of Justice found a serious error in the 2000 prospectus. The episode shaped a generation of German savers' view of shares.

The central lesson

Being right about a technology is not the same as being right about a price. If a price already assumes extreme growth for many years, even very good results can disappoint.

Worked example

Hypothetical example: a company's share costs €100 and its earnings per share are €1, so P/E = 100. Assume that after 10 years the market will value it at a more normal P/E of 20. Dividends, taxes and costs are excluded.

Case 1: the share price only stays at €100. At P/E 20, EPS must reach 100 ÷ 20 = €5. Required growth: 5^(1/10) − 1 ≈ 17.5% per year for 10 years, just to earn nothing.

Case 2: the investor wants 8% per year. Price after 10 years = 100 × 1.08^10 ≈ €215.89. EPS needed at P/E 20 = 215.89 ÷ 20 ≈ €10.79. Required growth: 10.79^(1/10) − 1 ≈ 26.9% per year for 10 years.

Very few companies grow profits that fast for a decade. If growth is "only" 12% per year, EPS after 10 years is about €3.11 and the price at P/E 20 is about €62, a loss of 38% despite a successful business.

Common mistake

Practice activity

On paper: a hypothetical share trades at P/E 60. You expect the P/E to fall to 25 within 8 years. (a) What yearly EPS growth is needed for the share price to stay flat? (b) What yearly EPS growth is needed for a 6% yearly price gain? (c) An investor holds 80% of her portfolio in such shares, and they fall 78%; the other 20% falls 10%. What is her total loss?

Key takeaways

• The Nasdaq fell about 78% from March 2000 to October 2002 and needed about 15 years to regain its peak in price terms.
• Germany's NEMAX 50 lost more than 90%, and the Neuer Markt closed in 2003.
• A correct technology story does not justify any price; high P/E ratios require years of extreme growth.
• Concentration in one theme turns a sector crash into a portfolio crash.

Next step

Lesson 7 continues with the global financial crisis of 2007–2009, where the bubble was in housing and the leverage was inside the banks.