Any type of bubble needs air to inflate. Whether it be gum, soap, or asset prices, bubbles can stretch beyond belief, expanding their walls to encompass more within. However, if one pumps one breath too many, the bubble pops; it pops because its walls are pushed too far. Speculative bubbles operate the same way. They occur when overly optimistic predictions about the future inflate the price of an asset above its real value. In the late 90s and early 2000s, the United States experienced a dotcom bubble when Internet stock prices rose, popped, and came crashing down. The dotcom bubble in the United States saw characteristics of heterogeneity in investors, an imbalance of optimism, short sale restrictions, and lockup expirations. This analysis offers a side by side comparison between the market environment that led to the dotcom bubble and Netflix, a present-day market, in order to determine whether or not there are warning signs which could be used in 2018 to identify speculative bubbles before they pop.
Throughout history, speculative bubbles have occurred from the Dutch tulip industry to the American housing market. It seems as if they are unavoidable. Ideally, bubbles should not exist in a state of equilibrium because “any transaction in a bubble that would make the seller better off would make the buyer worse off, and so, given that they have the same information sets, no trade would actually occur” (O’Hara 13). It does not take long to realize that this is not a perfect world where buyers and sellers have identical accurate information. Markets are complex and each case is unique. With this example, the internet is arguably unlike any other. In retrospect, no one could have predicted the rise of the internet or the sure might of the dotcom industry.
Yet, the strength of this new and exciting market does not explain what caused the dotcom bubble to occur as “internal dynamics of the market cannot lead to a feedback cycle in which one price increase begets another, creating a bubble and a later reversal of the cycle that fosters a crippling destabilization of the economy” (Stix 80). Other external factors were at play. For context, one can imagine how the dotcom era began with exuberance and untampered excitement. By 2000, the Internet sector was gaining momentum equaling “6 percent of the market capitalization of all the U.S. public companies and 20 percent of all publicly traded equity volume” (Ofek and Richardson 1113). With all this activity, the bubble was not simple; it was a complicated mixture of several financial issues and behaviors that led to the bubble.
The heterogeneity of investors at the time is one important aspect of understanding the bubble. The contemporary market consisted of different types of investors with varying levels of optimism about the internet’s potential. In essence, “there were many optimistic investors arriving to the market willing to pay high prices for Internet stocks; on the other hand, some pessimistic investors were willing to short these stocks at the high prices” (Ofek and Richardson 1116). This is a characteristic of a market that is self-perpetuating optimism when one considers the rationality behind confidence. Within conformity and contradiction, confidence grows exponentially. Over confidence in the market, or “the belief of an agent that his information is more accurate than in fact it is-is the source of disagreement,” can grow rapidly when confronted with opposition. Essentially, the more investors disagree, the more likely they will rally around their own opinion, spreading the levels of optimism and pessimism even further. All in all, this is not surprising as “a large literature in psychology indicates that overconfidence is a pervasive aspect of human behavior”.
On top of this aspect, systematically the market was concentrated with a different kind of investor. At the time, there were many retail investors in the market. “If more retail investors were in the market than under normal conditions, then one might reasonably argue that the market was more prone to the types of behavioral biases that lead to overly optimistic beliefs,” aggravating and intensifying the behavioral reasoning behind overconfidence (Ofek and Richardson 1121). These rationales bring to mind the image of a balloon inflating slowly but surely. The heterogeneity of the market is the air that inflates the optimism which starts off small but winds up filling the dotcom bubble up.
Additionally, short sale restrictions also inflated asset prices. A short sale is a transaction where people sell an asset that they borrowed which was bought at a higher price, and buy the asset back when the price goes down. With a diversity of investors, it was harder to short sell assets, which substantially changed prices. In equilibrium, prices are supposed to represent the average beliefs about the assets themselves. However, in an environment filled with different types of investors, some being more optimistic than others, short sale restrictions affect stock prices. In terms of the dotcom mania, short sale restrictions made more pessimistic investors exit the market, leaving only the optimistic investors. With people in the market feeling overconfident, prices inevitably went up (Ofek and Richardson 1113). These short sale restrictions halted pessimistic investors from actively selling, which would reflect their negative beliefs. Furthermore, short sale restrictions drove up the average optimism and prices. This is the reactionary effect of having a diverse amount of optimism within investors along with short sale restrictions.
After the dotcom bubble popped and prices plummeted. One factor in the deflation of asset prices is lockup expirations in 2000. Lockup agreements are contracts that make it impossible to sell any stock for a certain amount of time. Henceforth, “lockup agreements represent the most stringent form of short sale constraints,” which means that a lockup expiration is a break from the contract which releases those who were constrained (Ofek and Richardson 1114). So, the expirations unleashed a wave of pessimism. This had a significant effect on the number of assets in the dotcom market and the type of investors left in the market. As Ofek and Richardson put it, lockup expirations “results in (a) a permanent shift in the amount of available shares in the marketplace [and] (b) a shift in the class of investors” (1125). After the lock-up period ended, investors sold their shares and the changed prices reflected their pessimistic views, overtaking the previous majority of optimistic investors. With a shift towards pessimism in the air, prices inevitably dropped.
Again, the domino effect influenced the market. Once optimistic investors watched prices decrease, their sense of confidence diminished along with it. The shift in prices “had an effect on the ‘bubble-like’ beliefs of the optimistic investors” (Ofek and Richardson 1115). One can see how a shift in beliefs can lead to changes in price and how a shift in price can lead to a change in beliefs. This exemplifies the dangerous nature of bubbles as it highlights the significance that confidence and human behavior play in markets even today.
A different example does not tread far from the internet, as millions of people are pegged to their computer screens watching Netflix. In 2018, the dotcom bubble is in our past, but as one looks towards the future, there might be some bubbles waiting to pop. Undoubtedly, the popular streaming service is growing rapidly, as many people are starting to prefer this new way of watching TV and movies. It is a sign of the times as Celia and Peter Wiley write, “the ‘dot-commers’ of the nineties have become the ‘techies’ of the twenty-teens”. After two decades, this slight shift in focus still is evocative of the speculative bubble of the late 90s and early 2000s.
Currently, Netflix has an expansionary strategy so, “the company must keep churning out shows compelling enough to persuade more people to subscribe, and it needs to be able to continue borrowing money at low cost to finance its losses”. In general, the company takes on an aggressive approach, consequentially dealing with funding as an afterthought. They seem to be more concerned with growing their content rather than financing their expansion as “cash costs for Netflix’s streaming programming reached $8.9 billion in 2017, about double the costs from two years earlier. The number of Netflix streaming customers hasn’t increased as quickly. Yet, no one seems to be questioning the company’s success and their prevalence in pop culture and the streaming market. Perhaps, the overconfidence comes with their popularity. However, one should recognize overconfidence as a warning sign of a possible bubble. Like the dotcom mania, Netflix has the luxury of being a revolutionary platform with few competitors. For this reason, an analytical comparison of Netflix’s current state and the formation of the dotcom bubble is salient.
The overconfidence in Netflix is rooted in more than popular opinion. In terms of the asset market, “the company's enterprise value is more than 50 times estimated 2018 earnings”. As the dotcom bubble has taught us, asset values can seem great one day but change drastically the next. While Netflix enjoys these optimistic times, they should proceed with caution. There are so many unknowns when it comes to the market. Ovide echoes this sentiment, explaining that markets have no obligation to be consistent, compliant, or predictable, and the streaming market is no exception. These uncertain times and unforeseeable future are concerning. In addition, this cautionary tale should sound far too familiar as the Wileys discuss that, “the irrational exuberance…is inspiring more and more questions about whether the tech sector can sustain current levels of expansion or if we are headed for another bust". Similarly to the dotcom bubble, this herding is reminiscent of the way the internet asset market was saturated by optimistic investors who drowned out the pessimistic investors. If the factors previously discussed hold true, Netflix could have a bubble on their hands.
As a giant in streaming, Netflix seems far too relevant to even consider leaving their state of optimism anytime soon. The dotcom bubble has acted as a framework to understand the factors that can lead to speculative bubbles. In the late 90s and early 2000s, the United States’ economy faced problems when inklings of both optimistic and pessimistic investors in the marketplace, short sale restrictions, and lockup expirations carved the path leading to the rise and fall of internet asset prices. Although irrational in markets of equilibrium, bubbles occur and carry repetitive patterns that are intertwined with human behavior. For this reason, the characteristics of the dotcom bubble give rise to concern that Netflix’s bubble will inevitably pop.
Kumar, Amit. “When to Hold, When to Fold.” Short Selling: Finding Uncommon Short Ideas, Columbia University Press, 2015, pp. 205–208
Ofek, Eli, and Matthew Richardson. “DotCom Mania: The Rise and Fall of Internet Stock Prices.” The Journal of Finance, vol. 58, no. 3, 2003, pp. 1113–1137
O'Hara, Maureen. “Bubbles: Some Perspectives (And Loose Talk) from History.” The Review of Financial Studies, vol. 21, no. 1, 2008, pp. 11–17
Stix, G. (2009). THE SCIENCE OF Bubbles & Busts. Scientific American, 301(1), 78-85