Why the Dot-Com Bubble Was Far Less Irrational Than You Might Think

Markets Motley Fool

Wall Street has infamously had its share of ugly Octobers, so Alison Southwick and Robert Brokamp chose this month to offer their listeners a special treat: a four-part series on the history of market crashes in the United States. In this Motley Fool Answers podcast, guest and former Fool Morgan Housel leads the discussion on a topic near and dear to the hearts of online-based operations like the Fool: the dot-com bubble and the subsequent long and painful crash.

Continue Reading Below

On the surface, you may think you know what caused that mess: a torrent of money flooding into dippy ideas that were sold by folks who believed putting the word "internet" in front of them turned dross into gold. But plenty of dot-com bust victims were based on business models that were anything but crazy. The wild overvaluation of the bubble was also far less widespread than you might have thought, because the technology that underlay it really was pretty revolutionary.

A full transcript follows the video.

10 stocks we like better than Wal-Mart
When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, the Motley Fool Stock Advisor, has tripled the market.* 

David and Tom just revealed what they believe are the ten best stocks for investors to buy right now... and Wal-Mart wasn't one of them! That's right -- they think these 10 stocks are even better buys.

Click here to learn about these picks!

Continue Reading Below

*Stock Advisor returns as of October 9, 2017
The author(s) may have a position in any stocks mentioned.

 

This video was recorded on Oct. 17, 2017.

Alison Southwick: I was kind of around for the dot-com bubble. I was kind of alive. Not an investor. From my outsider perspective, it seems like this perfect storm of exuberance over this new thing, the internet, and not quite understanding it. These companies coming in. We know it's big. We don't know exactly why. But then investing in these companies also becomes a lot easier. That's my quick take, but you're going to give us the longer take.

Morgan Housel: I think that's exactly it, and those two points coming together at the same time is really what made it crazy, versus other times in history when there was a new industry that was coming along that was going to change the future. One, in the 1960s, was plastics -- which is almost funny to say. But that was the 1960s. Plastics was going to change the world, and the companies that were making plastics were the big, innovative companies that had huge growth in front of them.

But plastics didn't change how anyone invested at all. So you had a lot of excitement and you had overvaluation, but with the internet it was, "Hey, not only is this going to change the world, but now you can invest far easier and faster and cheaper," and you're just bombarded with more information than ever before. So you put those two together, and I think that's the backbone of what led everything to get out of control so quickly.

The other thing about this period is that when people talk about the dot-com boom, they talk about the late '90s. This is how they'd say it. Sometimes they'd say the 1990s. It was really only a 12-month or 18-month period in 1998 and 1999 that it got really out of hand. It really happened pretty quickly. And for most of the '90s, even when this was going on, there was growth and the stock market was doing well, but it was mostly rational and made a lot of sense for what was going on. It was just this blow-off top right at the end, where things started getting really crazy.

And a lot of that craziness was really only captured in a small number of companies in that period at the end. If you take a look at the stock market, most individual companies peaked in 1997-1998. It was the gains that the market experienced in 1999 when things were really getting crazy. The market was going up 30%, 40%, 50% and was driven by like five companies: AOL, Wal-Mart, GE. Just a few big tech companies. CiscoMicrosoft, Yahoo! That's where all of the overvaluation was.

But a lot of the hype ended way before that. So there's a lot of nuance in what happened that I think gets missed when we just lump everything into, "Oh, the '90s were a big, irrational, crazy time to invest." I think that's directionally true, but there's a lot that went on in between that that takes the story in different directions.

Southwick: When did things start warming up with the internet? It's like, the internet! It's a thing! When was that?

Housel: I think you have to take it back to personal computers, which was the '70s and '80s, and even then that's when Microsoft and IBM really started getting into the game, particularly like the mid- and early '80s. But even then it was still seen as something that a tech hobbyist would have in their house. We had people like Bill Gates who were the visionaries saying this was going to be on everyone's desktop, but very few people outside of Bill Gates and his...

Southwick: Core Radio Shack customers.

Housel: Exactly. Those people really started believing it until the early '90s, which is when Windows, as we know it, took off and the interface of personal computers really started making sense for people who had no tech background whatsoever.

Southwick: Oh, the mouse. The mouse! Clicking on things.

Housel: And not just the mouse. They had the mouse for a decade before that. But previous versions of personal computers, like MS-DOS, you really had to know what you were doing to get any usefulness out of it, and it was really the first version of Windows when it made sense. Like, oh, you have folders and you click on the folders and you have stuff in there. So that was the early '90s when it really started taking off and average, individual people could get something useful out of this.

And then in terms of when the internet started, really the first event that gets cited a lot as the birth of the dot-com bubble, when people really started opening it up to not just the internet's potential but the investment potential, was when Netscape went public, which was, I think, 1994. Shares doubled on the first day that it went public, and that was the first signal, the first example of what was to come, not just in terms of how this was going to change people's lives, but how it was going to change how people invested as well.

Southwick: Spoiler! Our young kids listening to the podcast have no idea what Netscape even is. So they're only the one that started it all.

Housel: That was a big deal, because before that you had the internet, but again, it was something that you needed to be a tech genius to use, and the browser was the first one that brought it to average, everyday people in a form that they could use.

Southwick: I always used Ask Jeeves.

Housel: I did, too. That was a good one.

Southwick: Ask Jeeves was a good one, too. And then Google came along and all those other ones, too.

Robert Brokamp: I was a teacher when the internet first started taking off. I got my first email address in 1994, and I still have that same email address.

Southwick: You do not!

Brokamp: I do! And for me, being a teacher, that just opened up your world, being able to show kids different things, to be able to pull up a video. YouTube wasn't around at that point, but you could still get videos. It was just mind-blowing.

And then from there I went to the financial-services industry. I started as a broker in 1997, and one of the first jobs you have to do there is cold call people. And every time I would cold call people they'd say, "I don't need you. I'm doing better on my own," which is not something you could say even in the late '80s, because you needed a broker to buy a stock. But that gets back to how things changed so much that you didn't need a financial advisor. I think also, looking back, that people were doing well because they were concentrated in tech stocks. Once the downturn came, they probably didn't do so well.

Housel: And what so many people did when they could start investing on their own was not investing on their own but day trading on their own. It was kind of the first iteration of, "Hey, I don't need a stockbroker. I can do this by myself. I don't have to ask anyone's permission. What am I going to do?" These are not buy-and-hold investors.

The whole concept of day trading was born in the 1990s when, here's your E*Trade account or TD Ameritrade-Datek. That was one of the big ones. Here's your Datek account. What are you doing to do? Are you going to just trade stocks all day? And because there was so much momentum in tech stocks, they were just going up day after day. That just made the concept of day trading that much more enticing. They not only had the opportunity to day trade, but maybe you could double your money in a day or a week. That just drew in all kinds of people who had no idea what they were doing and no business doing that.

Brokamp: Earlier this year, Bespoke Investment Group published a table of the composition of the sectors of the S&P 500 over various increments. So you look back at 1990. Tech stocks made up 6.3% of the S&P 500. By 1995 it was 9.3%, so growing. By 1999 it was 29% of the S&P 500. And they have all the sectors going back to 1990 up until 2017, and at no point do you see any other sector making up that much of the S&P 500.

Housel: And so much of a gain in that way -- back to what we were saying earlier -- was really just a handful of companies. Yahoo, Cisco, AOL...

Brokamp: Lucent.

Housel: Lucent. There were a few companies that were worth hundreds of billions of dollars and that were really driving the bulk of that.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Alison Southwick has no position in any of the stocks mentioned. Morgan Housel has no position in any of the stocks mentioned. Robert Brokamp, CFP has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Alphabet (A shares) and Alphabet (C shares). The Motley Fool recommends Cisco Systems. The Motley Fool has a disclosure policy.