Why the Bubble's in Trouble

By Joanna Glasner
Wired

April 11, 2000

The problem with a stock bubble is you never really know it is one until it pops.

That was a lesson learned the hard way for tulip investors in 17th century Holland.

But lately, after months of run-ups, record-breaking IPOs, and an investment climate approaching euphoric, the tech stock market has been curtailing its excesses. Newly public companies have taken a hit in the aftermarket, while former high-flyers like eToys and CDNow have seen shares plummet. At the same time, fears are surfacing that a number of once-promising dot coms are nearly out of cash.

The downturn has spurred a renewed round of speculation that the so-called Internet bubble -- that vast pile of paper wealth tied up in New Economy stocks -- is poised to get a lot more air sucked out of it.

"The bubble isn't going to burst. It'll just deflate," said David Menlow, president of IPOFinancial.com, who predicts a gradual slowdown bringing Net stock prices closer to earth.

The vision was shared by a number of academics, Wall Street analysts, executives, and venture capitalists who, in the wake of last week's record-setting week of volatility on the Nasdaq exchange, offered their views on how and when the Internet wealth boom will reverse course.

Their conclusion: The Internet stock market is entering a far less giddy phase. Although investors aren't shifting out of the industry in droves, they are getting pickier about which companies they hold on to and how much they're willing to pay for shares.

It's not so much the big crash, however, as an "important corrective trend" -- the phrase Merrill Lynch chief market analyst Richard McCabe used Monday. McCabe predicts more ups and downs ahead for Internet stocks, rather than an across-the-board decline.

Still, that's causing some pain along the way.

"Clearly, the markets are moving out of this hyper-growth period into a more rational growth period," said Gregory Hawkins, CEO of Buy.com (BUYX), one of the companies that has taken a big hit in recent weeks.

Shares of Buy.com, which peaked above $35 during the company's February IPO, have since slumped to $8.

The stock drop comes amid a broader decline in shares of online retailers this year. Market watchers are still searching for the best term to characterize the downturn.

"I'm not so sure if I'd call it a bubble or more a realization that cash flows do matter," said Todd Pulvino, a finance professor at Kellogg Graduate School of Management. Pulvino is another member of the camp predicting a gradual pullback, rather than a free fall, for Internet stocks.

"Stock bubble" is not just a metaphor, said Eric Brynjolfsson, a professor at MIT's Sloan School of Management who specializes in e-commerce. It's actually a term economists use to describe unrealistically optimistic valuations.

Traditionally, stocks are valued based on what economists call the present value of future earnings. That is, investors buy stock in company based on what it makes now, plus what it's expected to make down the road.

In a bubble, however, investors overvalue a company's future earnings. A company that might never turn a large profit might be worth billions -- setting the stage for a steep fall. Given that definition, it would seem at first glance that Net stocks are a classic bubble. Most Net companies are unprofitable, or barely profitable, and their stocks have garnered huge valuations.

But Brynjolfsson points out that Net companies are notoriously ill-suited to traditional models for assessing value. For one thing, technology companies have been growing at a far faster rate than other industries. Secondly, although certainly not all Internet companies that have savored lofty valuations will survive, a few will flourish and grow even bigger.

Shanda Bahles, a managing partner at the venture capital firm El Dorado Ventures, sees the latest downturn in e-commerce stocks not as a sign of the bubble bursting so much as an example of how quickly sectors go out of style in the Internet business. Early last year, when there weren't a lot of Internet retailers on the stock market, most of them got very high valuations.

"Each of these companies, when they first come out, have been valued as if they were winners in the space," Bahles said.

Now investors are starting to weed out the also-rans.

Bahles compares the current plight of e-commerce companies to what happened with Internet service providers a few years ago. Although there are still plenty of ISPs in business, only a few have large stock values. America Online, meanwhile, has emerged as the uncontested heavyweight of the lot.

The scenario isn't too different from what Federal Reserve chairman Alan Greenspan predicted would happen to the dot-com crowd way back in January 1999, when he compared the Net stock market to a lottery.

"Undoubtedly some of these small companies, which have stock prices going through the roof, will succeed and they very well may justify even higher prices," he said. "The vast majority are almost sure to fail. That's the way the markets work in this regard."

The lottery system works because humans are notoriously bad at evaluating probability, Brynjoffson said. As a result, they systematically overpay for things like lottery tickets. Some would say the same logic applies to Internet stocks.

In their unfettered optimism for the future of Internet technology, investors forgot that dot-com companies will some day have to back up their potential with quantifiable performance.

The big problem for those on the Net stock doomsday watch, however, is defining what it means to be overvalued.

Many investors, for example, might have thought Amazon.com (AMZN), a company that has yet to report a profit, was overvalued at $3 billion or $4 billion. Now, even with a weak performance this year, it's worth $22 billion.

At the same time, investors who bought into eToys (ETYS) its first day out -- when the company garnered a stock market value of more than $8 billion -- weren't getting any bargain. The company is now valued at less than a billion dollars.

Clearly, it's not easy for investors to figure out when to get out, and whether they stand to lose or gain by selling stock in a company shortly after a lucrative debut.

That's the gist of one of the more noteworthy anti-bubble arguments, promulgated by a fictional character.

In Kurt Anderson's Turn of the Century, one character says the Internet economy is less like a bubble and more like foam. Small bubbles arise, sometimes forming into bigger bubbles. And even though individual bubbles may pop, foam always advances.

Whether foam's stock price advances, however, is another story.

Copyright 2000, Lycos, Inc.