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May 2004, by Tony Golding “This Time It Is Different ”– Introduction One of the advantages of trying to make sense of the internet boom of the late 1990s – and the subsequent bust – so soon after the event is that it’s fresh in everyone’s memory. Many became caught up in the boom while it lasted. People who now say to themselves: “How could I have believed the absurd growth projections that were being made for all sorts of industries and activities at the time?”. The reason is that enough people became convinced that the rules of the economic game had been changed; that the internet heralded, for the US economy and, by extension, the world economy, the emergence of a self-perpetuating growth machine. None of this is new. The parallels in economic history are both numerous and fascinating - and instructive. This short paper tries to answer four questions: 1. What happened during the internet bubble? What Happened During the Internet Bubble? We all know what happened during the period when the Web grew from an obscure idea to something that has transformed our lives and the way we work. Companies were created and new ventures pursued on the basis that so fundamental was this change that opportunities for growth and profit were there by the million. With some - relatively few - exceptions, the excess capital thrown at these perceived opportunities was lost or now earns low or negative returns. What is a bubble? Charles P. Kindleberger, who was for many years a Professor of Economics at MIT, wrote a classic book on what he referred to as “financial crises”. It’s called “Manias, Panics, and Crashes”. In it, he talks about the point at which buying and selling assets for speculation becomes general within a community. When individuals or firms see others making a profit from speculative purchases they tend to follow. Kindleberger puts it rather nicely. When he gives talks on this subject he uses a polished one-liner that always gets a nervous laugh: “There is nothing so disturbing to one’s wellbeing and judgement as to see a friend get rich”. When speculation becomes general and leads away from normal, rational behaviour he terms it a “mania” or “bubble”. “Mania” emphasises the irrationality; “bubble” foreshadows the bursting. The internet bubble started with the Netscape IPO in the summer of 1995. In the USA, between August 1995 and March 2000, 450 internet-related companies went public, fuelled by a seemingly boundless investor appetite. The rapidly developing technology caught the imagination of the American investing public, who invested directly in new issues or via mutual funds. Twenty years ago I wasinvolved as an investor in a mini high-tech boom that affected US stock markets for a couple of years. The rule then was that investors would only buy into newly-floated companies that were profitable, even if they had only just reported black figures. But, with the internet, things were different. So desperate were investors to grab a slice of this revolutionary, world-changing technology that “concept became king” – not mundane things like profit! At the height of the boom, 90% of companies were loss-making when they came to the market. Most of these once “hot” companies have fallen by the wayside. Events in the UK mirrored those in the US though, in Europe, timescales were compressed. The boom was probably as intense over here but only lasted for 18-24 months. Why Did the Internet Boom Occur? One fundamental reason why the emergence of the internet led to a financial boom of such dimensions lies in the pervasive nature of the technology and its consequential impact on individual investors – a rapidly expanding breed in the nineties, especially in the USA. Millions of Americans could see for themselves the power of the internet and were easily persuaded that here was a highly significant, economically world-changing technology. But pervasive does not necessarily mean profound. In other words, users said to themselves: “If it does great things for me I’m prepared to believe it will do great things for the economy as a whole”. So, if that was the backdrop to the late 90s boom, what were the other factors? First of all, we shouldn’t forget that the beginning of the 1990s coincided with the fall of Communism. There was a feeling of triumphalism around that became mixed up with patriotic self-congratulation. I don’t think it is too far-fetched to argue that this feeling of confidence in America spilled over into the stock market. One of the most intriguing factors behind the 1990s boom was what was happening on the macroeconomic front. In the summer of 1996 Alan Greenspan, the Chairman of the Federal Reserve, was far from convinced that a speculative bubble had developed. This view was shared by Wall Street, but then Wall Street is hardly an objective observer! Greenspan inclined to the view that the old rules--of-thumb about the economy no longer worked. The Chairman agreed with what many were advocating at the time: that American firms were becoming more productive. According to official figures, the service sector of the American economy had seen virtually no productivity growth over the last three decades. But how could that be, he wondered, given the revolution in Information Technology? You only had to look at your local bank to see how automated the business had become. He remained unconvinced that corrective action was needed. On December 5, 1996 Alan Greenspan made a speech to the American Enterprise Institute, a conservative think-tank in Washington. In it he made a brief reference to the current situation, posing a question rather than making a statement. “How do we know” he said “when irrational exuberance has unduly escalated asset values?” The media seized on the phrase “irrational exuberance” and stock markets went into reverse. But not for long, and by the end of the trading day the Dow Jones Index had lost less than one per cent. Wall Street read this as meaning Greenspan was prepared to indulge in exhortation but not actually do anything to raise interest rates and curb rising stock prices. What appears to have changed Greenspan’s mind was the extent to which, by early 2000, the stock market bubble was feeding into the real economy through “the wealth effect” – people feeling richer and going on a wild spending spree. The US economy was growing at twice its normal long-term growth rate. In early February the Fed raised rates by a quarter of a point but, more crucially, warned that further hikes were on the cards. A second increase in the third week of March finally pricked the bubble. The Role of Investors The UK equity market is dominated by institutional investors. Forty years ago private individuals owned over half the shares quoted on the London stock market. Today that figure is down to 16%. So you now have a situation where stock markets are largely controlled not by millions of ignorant, emotional and easily swayed private investors – of course, not all can be characterised in this way but I’m exaggerating to make my point - but by 50 or 100 large organisations run by intelligent, sensible people who, for the most part, are set long-term objectives. Surely the existence of these institutions should act as a restraint on excessive speculation, as a bulwark of rationality against the unjustified bidding up of asset prices we saw in past booms? In short, the internet bubble shouldn’t have happened. The theory is seductive but, unfortunately, it doesn’t work like that. I can do no better than quote from Warren Buffett, the legendary American investor who sits in Omaha and comments – sagely – from afar on the bizarre practices and iniquities of Wall Street. In his 1985 annual letter to his shareholders he said: “You might think that institutions, with their large staffs of highly-paid and experienced professionals, would be a force for reason and stability in financial markets. They are not.” Why are institutions not “a force for reason and stability”? The short answer is that they try to be but are frequently overwhelmed by what’s actually happening in the market place. Markets, at least in the short-term, are driven primarily by emotion – what in the City is referred to as “sentiment”. Share prices are made “at the margin”. On a typical day perhaps 1-2% of the shares in a large company change hands. What determines the price that is struck at the end of the day is the balance between these buyers and sellers. It does not reflect the views of the 98-99% of holders who choose to do nothing. So it only takes a minority of professional fund managers who are pursuing shorter-term and riskier trading strategies to keep pushing the market up, to valuations that the majority of fund managers may regard as excessive but feel they have no choice but to live with. Another important reason why fund managers became participants in the sharp upswing in share prices has to do with the dynamics of the fund management business. Whatever their private views, the way the system works is that, in practice, there is often intense business pressure on the people who run pension funds and insurance money to follow “the crowd”. Private investors played a greater role during the boom in the USA than here in the UK, both directly and indirectly. In the first place, the US has a much higher proportion of direct retail involvement in the stock market. Secondly, compared with unit trusts, mutual funds are relatively much more important as an influence on Wall Street. Much of that greater influence has to do with the way the pension system developed in America in the 80s and 90s. The contributor to a traditional Defined Benefit (DB) pension scheme has no influence over the investment policy of the fund. But in Defined Contribution, or DC, plans the individual can allocate contributions as they see fit, within limits. They certainly have the scope to decide what proportion of their fund goes into equities. And, in the USA, they can often select a particular fund, such as a technology fund. The shift we are seeing currently in the UK from DB to DC pension schemes happened much earlier in the USA and, in my judgement, was a significant contributory factor to the bull market and its ultimate excesses. As the bull market gathered momentum, more and more DC plan participants put more and more of their contributions into the stock market, usually by buying mutual funds, so adding fuel to the internet boom. It is also clear that many Wall Street analysts chose to cast a less than critical eye at what was happening at Enron and many other companies. Several parts of the bank they worked for were benefiting from the largesse that Enron and others were dispensing so liberally, so there was every incentive to keep on recommending investors to “Buy”. While the institutions took the recommendations issued by investment bank equity analysts with a large pinch of salt, nobody bothered to tell Joe Public any of this. So he or she took the recommendations at face value and kept on buying! What Can We Learn From the History of Financial Bubbles? If we look at history we find that most revolutionary technologies were accompanied by bull market euphoria, but not all. The economic and investing background has to be right. Alexander Graham Bell had a hard time convincing American investors in the 1880s that his invention, the telephone, was anything but a toy because the collapse of so many railway companies was still fresh in people’s minds. Twenty years later several competing radio companies had no problems raising capital from investors, even though radio technology was considerably less developed than the telephone had been when Bell was trying to raise money. By that time investors were once again ready to take risks on technology, encouraged by seven years of share price rises. Let us take a look at one particular technology: the railways. We shouldn’t forget that, at the time, the introduction of railway travel was every bit as revolutionary as the internet in the way it changed people’s lives – in fact, probably more so. In Britain, enthusiasm for the new technology was boundless, reaching a mini-peak in 1837 and a final peak in 1845 in the great “Railway Mania”. Between 1843 and 1845 the index of railway share prices doubled. Investors clamoured for new issues. New lines were proposed from everywhere to everywhere. Capital was plentiful and, for a time, the problem was not one of funding, but – as with the internet bubble – finding enough new companies for investors to put their money into. Prospectuses for new issues were sketchy in the extreme. As with dot com companies 150 years later, there was little demand for rigorous analysis. It was enough to say you were in the railway business. Then, in 1847, railway share prices collapsed and hundreds of companies went out of business. How Likely is it That Something Similar Will Happen Again? Will it happen again? I’ve no doubt it will. Technology may change, economic institutions and techniques may become more sophisticated - but human nature doesn’t change. I would argue that these major speculative booms and their subsequent crashes only happen two or three times a century. The reason for this is simple. Investors who became caught up in the sheer unbridled optimism of the upswing need time to forget how easily they were seduced. That’s why a generation needs to elapse. Those who were in the forefront of the dot com revolution – as participants, investors or cheerleaders – who were in their 20s and 30s at the time are unlikely to forget how they got caught up in the hype. And how it all went wrong for all but a few. In 30 years’ time that collective memory will have lost much of its force because a new generation of 20 and 30-somethings will be making the running. They may not be heading the large corporations but society will I suspect, as now, look to them for their creative and entrepreneurial energy. Some amazing new piece of technology will come along that appears to have the potential to change the world forever and share prices will climb to giddy heights once more. The new generation of entrepreneurs will, as they did during the internet boom, be saying to the doubters what Sir John Templeton, one of the pioneers of equity investment, calls the four most expensive words in the investing language: “This time it’s different”. It’s the “New Economy” they said five years ago. You can’t judge share prices by the old yardsticks, they will say, because the world has changed. And their convictions will be so strong that they will overwhelm the doubters. But it won’t be different. Because it never is. And the cycle will continue its upswing followed by the inevitable collapse. As the philosopher George Santayana famously said: “Those who cannot remember the past are condemned to repeat it.” This paper is based on a lecture given to the annual Economics Summit Conference at Warwick University in February 2004.
About the Author After graduating from Cambridge and the University of Sussex, where he gained a doctorate in industrial economics, Tony Golding spent several years with an international electronics company. He entered the City in 1974 and spent 24 years there, starting as an investment analyst with a small, research-based firm of stockbrokers. In 1978 he joined Flemings, the London-based investment bank (which is now part of J.P. Morgan Chase), becoming a director and head of research in the asset management division. Before Big Bang in 1986 he took responsibility for setting up the research and sales functions in Flemings’ newly established securities operation. In 1989 he moved over to investment banking, where he specialized in the generation and marketing of acquisition and equity-financing ideas in several industry sectors. He left in 1998 to write “The City: Inside the Great Expectation Machine” which, in September 2002, went into its second edition.
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