The Internet Bubble of the late 1990s

Another stock market event ofter cited by behaviouralists as clear evidence of the irrationality of markets is the Internet "bubble" of the late 1990s.

Surely, the remarkable market values assigned to Internet and related high-tech companies seem inconsistent with rational valuation. I have some sympathy with behavioralists in this instance, and in reviewing Robert Shiller’s (2000) Irrational Exuberance, I agreed that it was in the high-tech sector of the market that his thesis could be supported. But even here, when we know after the fact that major errors were made, there were certainly no arbitrage opportunities available to rational investors before the "bubble" popped.

Equity valuations rest on uncertain future forecasts. Even if all market participants rationally price common stocks as the present value of all future cash flows expected, it is still possible for excesses to develop. We know now, with the benefit of hindsight, that outlandish and unsupportable claims were being made regarding the growth of the Internet (and the related telecommunications structure needed to support it).

We know now that projections for the rates and duration of growth of these "new economy" companies were unsustainable. But remember, sharp-penciled professional investors argued that the valuations of high-tech companies were proper. Many of Wall Street’s most respected security analysts, including those independent of investment banking firms, were recommending Internet stocks to the firm’s institutional and individual clients as being fairly valued. Professional pension fund and mutual fund managers overweighted their portfolios with high-tech stocks.

While it is now clear in retrospect that such professionals were egregiously wrong, there was certainly no obvious arbitrage opportunity available. One could disagree with the projected growth rates of security analysts. But who could be sure, with the use of the Internet for a time doubling every several months, that the extraordinary growth rates that could justify stock valuations were impossible? After all, even Alan Greenspan was singing the praises of the new economy. Nothing is ever as clear in prospect as it is in retrospect. The extent of the "bubble" was only clear in retrospect.

Not only is it almost impossible to judge with confidence what the proper fundamental value is for any security, but potential arbitrageurs face additional risks. Shleifer (2000) has argued that "noise trader risk"—the risk from traders who are attempting to buy into rising markets and sell into declining markets—limits the extent to which one should expect arbitrage to bring prices quickly back to rational values even in the presence of an apparent bubble.

Professional arbitrageurs will be loath to sell short a stock they believe is trading at two times its "fundamental" value when it is always possible that some greater fools may be willing to pay three times the stock’s value. Arbitrageurs are quite likely to have short horizons, since even temporary losses may induce their clients to withdraw their money.

While there were no profitable and predictable arbitrage opportunities available during the Internet "bubble," and while stock prices eventually did adjust to levels that more reasonably reflected the likely present value of their cash flows, an argument can be maintained that the asset prices did remain "incorrect" for a period of time.

The result was that too much new capital ‘ owed to Internet and related telecommunications companies. Thus, the stock market may well have temporarily failed in its role as an efficient allocator of equity capital. Fortunately, "bubble" periods are the exception rather than the rule, and acceptance of such occasional mistakes is the necessary price of a flexible market system that usually does a very effective job of allocating capital to its most productive uses.

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