Dot.Con: The Greatest Story Ever Sold

by John Cassidy

wave of IPOs, the supply of Internet stocks remained severely restricted.

together reflected an ominous decline in “civic society.”13 Putnam’s was an interesting thesis, and it had some truth to it, but it ignored the proliferation of one type of voluntary association where millions of Americans gathered regularly, talked with each other, and acted in unison on an issue close to their hearts: money.

In the summer of 1998, three economists published an article in The Journal of Economic Perspectives entitled “Learning from the Behavior of Others: Conformity, Fads, and Informational Cascades.”17 Sushil Bikhchandani, David Hirshleifer, and Ivo Welch tried to explain why very different people often end up doing the same thing, such as wearing the same brand of shoes, watching the same television shows, or putting their money in Internet stocks. The key to such fads, the economists argued, is “social learning”—learning from the actions of others.

20,000, 30,000, or even 40,000. In such an environment, as the sociologist Gustav Le Bon wrote in his classic book The Crowd: A Study of the Popular Mind, an individual “is a grain of sand amid other grains of sand, which the wind stirs up at will.”

Each of these companies was heading for an early IPO, which is why they were able to raise so much money. The days when VCs nurtured investments for five or ten years before selling them to the public were over. These days, twelve months was a long-term investment horizon. Many VCs had reservations about what was happening, but they were just as trapped in follow-the-leader logic as the investment bankers and the mutual fund

By the middle of 1999, the VCs were competing with one another for the privilege of financing the next Internet business plan that came through the door, and all prior rules had been suspended. “It was absurdly easy,” a young Harvard Business School graduate who helped raise several million dollars for an Internet start-up in the fall of 1999, recalled. “You would walk into offices in New York and people would immediately offer money to you if they thought you looked smart. We didn’t have any data on the market; we didn’t have a product demo; we didn’t have anything. We had a business plan, but that was

The task of building the company was secondary—a chore that had to be performed before the IPO, but not the real reason why Harvard MBAs like Andrea Reisman, Petopia’s chief executive, were giving up promising careers elsewhere. Pet food is only pet food, even to a Harvard MBA.

Soros used the word “reflexivity” to describe this self-reinforcing process because the rise in stock prices reflects the apparent improvement in the economic outlook, and

the improvement in economic outlook reflects the rising stock prices.

Unlike some Internet zealots, Bezos never claimed that traditional retailing would go away. He knew that human beings were active and gregarious creatures that liked to go out and shop. But he believed about fifteen percent of retail spending—more than $500 billion—would eventually go online, and he wanted to grab a large part of that for Amazon.com. Bezos insisted that his strategy was based not on a Napoleonic ego, but on increasing returns to scale. As Amazon.com expanded into new areas, its revenues would grow faster than its costs, he argued. Unlike regular retailers, it didn’t have to build new stores and staff them up in order to grow. The zShops initiative was a good example of this strategy. Whenever an online customer bought something in a store that he or she had entered from Amazon.com, Amazon.com received a commission.

The real significance of the merger between America Online and Time Warner was the confirmation it offered that the old media and the new media were converging—a convergence that had devastating implications for Internet stocks. After all, the main rationale put forward for the high prices of these stocks was that Internet companies were completely unlike ordinary businesses, so standard methods of valuation didn’t apply. In using America Online’s inflated stock to buy Time Warner, Case held this argument up to the light, where it could be examined. Once there, it didn’t look very convincing. America Online and Time Warner, it turned out, were both media companies that sold editorial content to the public and charged for it, largely, by subscriptions.

Yahoo!’s financial strategy, which relied on advertising for revenue, also seemed to be paying off. The day after the America Online–Time Warner press conference, it announced profits of $44.7 million for the fourth quarter of 1999. For the year as a whole, Yahoo! earned $61.1 million on revenues that had jumped 140 percent to $588.6 million. More than three thousand companies were now advertising on Yahoo! In anticipation of the earnings release, Yahoo!’s stock broke through $500, a new all-time high, valuing the firm at $131.6 billion. There is a lot of competition, but this may well have been the most exaggerated valuation ever placed on an American company. Yahoo! was now worth more than Walt Disney and News Corporation combined. Its stock market valuation was 224 times its 1999 revenues and 2,154 times its 1999 earnings.

Moreover, the real economy and the financial economy were now intertwined—a classic symptom of a late-stage speculative bubble. The rising stock market had fueled an unprecedented spending spree on the part of consumers and firms, which, in turn, had caused economic growth to accelerate.

Accelerated productivity growth had two effects. On the supply side of the economy, it encouraged firms to expand capacity. On the demand side, it sparked a run-up in stock prices, as investors looked forward to the higher profits that the new technology would generate.

The rise in stock prices, in turn, led to an increase in consumer spending through the “wealth effect.” People felt richer, so they spent more.

Building factories and getting all the new technology to work together was no simple matter. By contrast, the rise in stock prices, and the concomitant increase in consumer spending, was immediate. Consequently, overall demand in the economy rose faster than overall supply. It was this “imbalance between growth of supply and growth of demand that contains the potential seeds of rising inflationary and financial pressures that could undermine the current expansion.”

once good idea had degenerated into a nonsensical ritual. Even sober television viewers seldom remember more than one or two of the ads they watch—a fact confirmed by Harris Interactive, a Rochester-based polling firm, which surveyed the Super Bowl viewers.7 More than half of the respondents said they recalled seeing E*Trade’s offbeat ad, which featured a dancing chimpanzee and the line “We just wasted two million bucks,” and four out of ten remembered the Pets.com sock puppet. But just three in a hundred recalled Computer.com’s ad, and even fewer remembered kForce.com.

The market had entered what Hyman Minsky, an economist who specialized in financial manias, termed the stage of “revulsion.” This takes place at the very peak of a bubble. Investors realize the game is almost up, and they become more discriminating. Some discreetly cash in their gains. The market has some good days, and it may even rise further, but it also becomes increasingly volatile amid the general recognition that the easy money has already been made.

When will the Internet Bubble burst? For scores of ’Net upstarts, that unpleasant popping sound is likely to be heard before the end of this year. Starved for cash, many of these companies will try to raise fresh funds by issuing more stock or bonds. But a lot of them won’t succeed. As a result, they will be forced to sell out to stronger rivals or go out of business altogether. Already, many cash-strapped Internet firms are scrambling to find financing.

Many firms struggled to raise money, which led to a sharp decline in investment spending, especially on technology. The fall in investment caused a slowdown in economic growth and productivity growth,

which, in turn, led to a drop in corporate earnings. With earnings falling, the stock market came under more selling pressure,

On Friday, March 9, 2001, the anniversary of the Nasdaq first closing above 5,000, the index ended the day at 2,052.78. In twelve months, the total market value of companies listed on the Nasdaq had dropped from $6.7 trillion to $3.2 trillion: $3.5 trillion in stock market wealth had vanished. Cisco Systems, which a year earlier had been the world’s most valuable company, worth $466.5 billion, was now valued at $164.2 billion. Yahoo!’s stock market value had fallen from $93.7 billion to $9.7 billion, Amazon.com’s from $22.8 billion to $4.2 billion. The Dow Jones Composite Internet Index, which on March 10, 2000, closed at 509.84, now stood at 80.74, a fall of 84.2 percent.

Most Internet start-ups failed because they were based on the mistaken premise that the Internet represented a revolutionary new business model, which it didn’t. It is a tool that companies can use to build their business if they can combine it with distinctive products and avoid ruinous price wars, but nothing more than

But some of the biggest buyers of information technology, such as the banking and media industries, recorded hardly any productivity growth at all. The industries that enjoyed the most productivity growth during the 1990s were the producers of information technology (such as the personal computer industry), which benefited from Moore’s Law, not the users of information technology.

The fundamental lesson of a speculative bubble is that behavior that seems rational at the individual level can lead to collective insanity. Trapped in the logic of herd behavior, Wall Street will inevitably keep inflating the bubble until it bursts. It is up to journalists and government officials to try to maintain sanity, but in this case neither proved up to the task. Despite some honorable exceptions, the overall standard of reporting on the Internet stock phenomenon was dismal. In many cases, CNBC being only the most obvious example, the media became an active participant in the bubble, turning entrepreneurs like Jeff Bezos into celebrities, and parroting the Wall Street line on stocks like Yahoo! and Amazon.com. Economics was largely responsible for this deterioration. The Internet boom created a vast new source of advertising, which newspapers, magazines, and television networks rushed to exploit.