While the internet boom lasted, nothing seemed able to deflate the bubble. Few internet and dot com companies were profitable, but investors never seemed to mind. They looked at the number of customers or subscribers as the basis for valuing internet stocks. The name of the game became raising capital, not making profits. Even when fashionable stocks dipped, there was remarkably little effect on the rest of the market. People had learned that it pays to buy the dips, and were not weaned from the habit until it ceased to pay.
Now that internet fever has abated, we hear that the “fundamentals” are reasserting themselves. But this view is as much a half-truth as the previous notion that the boom would last forever because the internet economy had created new fundamentals. Indeed, the internet boom/bust cycle brings into question prevailing economic theories about financial markets.
What should now be clear is that the so-called fundamentals that supposedly determine stock prices are not independently given. Instead, they are contingent on the behavior of financial markets. There are, indeed, myriad ways in which stock prices affect the fortunes of companies: they determine the cost of equity capital; they decide whether a company will be taken over or acquire other companies; stock prices influence a company’s capacity to borrow and its ability to attract and reward management through stock options; stock prices serve as an advertising and marketing tool. In other words, when financial markets believe a company is doing well, its “fundamentals” improve; when markets change their mind, the actual fortunes of the company change with them. Moreover, changes in financial markets also have far reaching macroeconomic consequences.
It did not take a genius to realize that the internet boom, based not on profit expectations but on the expectations of selling stock to the public at ever increasing prices, rested on an unsustainable business model. It also did not take a genius to see that boom would be followed by bust, but it was harder to guess when that bust would occur. In the summer of 1999 I was convinced that an internet crash was imminent. Yet internet stocks recovered from a short dip; some soon rose to new highs. Institutions that live and die by relative performance felt obliged to increase their internet holdings. When Yahoo was included in the S&P 500 Index, it jumped 30% in a day. People like me who had sold internet stocks short in the belief that a crash was imminent were forced to cover them at whopping losses. I remained convinced that a bust was bound to come, but I could not afford to stand by my convictions.
Despite its irrational aspects, the internet boom was more than a matter of inflated valuations. The optimism of the financial markets not only changed the “fundamentals” of individual businesses, it had real and profound effects throughout the whole economy. The boom did not only follow from the development of the internet; it accelerated that development and contributed to the speed and extension of technological innovation. The same was true in telecommunications, where the boom also accelerated the spread of new technology.
The internet bust, when it finally came, was caused not by an unsound business model, but by over-extension of credit. The present slowdown is affecting the fundamentals of individual companies almost as much as their stock prices; it also affects the financial system and macroeconomic performance.
Instead of a one-way connection in which financial markets discount the future more or less accurately, there exists a two-way connection in which financial markets shape the future they are supposed to discount. Instead of a single outcome, there is a range of possibilities. Which of those possibilities materializes depends not only on the future evolution of the so-called fundamentals but on financial market behavior as well.
In these circumstances, it is irrational for market participants to base their decisions solely on their expectations about fundamentals because the fundamentals do not determine market prices; on the contrary, they are shaped by market conditions. So what matters to market participants is the future course of market prices, not the fundamentals they are said to reflect. If market prices deviate from a theoretical equilibrium there can be no assurance that they will ever return to it.
This is why the recent boom/bust sequence in internet and telecommunication stocks is so revealing. These developments cannot be explained in terms of efficient markets and rational expectations. I have proposed an alternative explanation based on the two-way connection between fundamentals and valuations which I call “reflexivity”.
I am amazed and amused that economists ignore my arguments. They claim that the phenomenon of reflexivity is already taken into account in the concept of multiple equilibria which has gained acceptance recently. Maybe so, but I have yet to see how persistent movements away from a theoretical equilibrium can be explained within the framework of multiple equilibria. Any divergence from equilibrium, whether one assumes that there is a unique equilibrium or many equilibria, amounts to more than noise; it is a causal factor in determining the very nature of the “equilibrium” that will prevail. By ignoring this condition, efficient market theory presents a totally misleading picture of financial markets.
Why is my reasoning dismissed out of hand? Because it leads to the conclusion that financial markets are inherently unpredictable. What is the value of a scientific theory, I am asked, if it does not yield useable predictions? I contend that it would be better to recognize the uncertainties inherent in the behavior of financial markets than to cling to a supposedly scientific theory that distorts reality. One consequence of the realization that financial markets are potentially unstable, is a recognition of the need for financial authorities to make it their business to prevent excesses. The debate about efficient markets may be arcane, but the consequences for our lives are very real indeed.