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.