Executive Summary
In this management report, the history of dot.com mania, as well as investor behavior in general, are studied from a psychological perspective. The analysis shows that investors of the 2000s were driven by their irrational and unconscious emotions, which resulted in the appearance and bursting of the dot.com bubble. Further, research shows that, currently, stock markets are in another bubble that may pop soon, and there are both similarities and differences between the two bubbles discussed in the paper. The technical term ‘phantastic object’ that helped researchers explain the unconscious appeal of dot.com stocks and understand the Global Financial Crisis is applied in this paper to analyze the valuations of unicorns, new listings, and internet and cloud-based stocks. Finally, emotional finance and behavioral finance theories are applied when explaining the current and predicting the future market.
Introduction
Stock markets and the economy as a whole have a number of difficulties and unforeseen situations that may entail different circumstances. Over the past hundred years, rather important and interesting events have taken place in the world economy, and some are still being researched by specialists. One such phenomenon is the dot.com bubble of 1995-2000, which later caused a serious crisis and still makes investors and researchers worried about its recurrence. This management report has a number of significant objects and purposes. First, it aims to get insight into the phenomenon of a stock market bubble. Then, it attempts to understand the history of dot.com mania from a psychological perspective and find out whether there is currently another bubble about to burst. Finally, the purpose of this report is also to compare and contrast the relative contributions of emotional finance and behavioural finance to helping understand the psychology underpinning present market valuations and the behaviour of asset markets more generally.
This report is motivated by the author’s curiosity and desire to understand the importance of viewing the fund management industry through behavioural and emotional finance lenses rather than drawing on traditional normative finance theory. This paper is divided into several sections and subsections, which makes the navigation easier, while several figures are added to make the report more visual. The first section is devoted to an overview of the dot.com bubble and a comparison of the current and past markets. The second and third sections contain arguments supporting different points of view regarding whether there is a bubble in the market now and at what stage it is. The rest of the paper is devoted to emotional finance, behavioural finance and more traditional economic theory.
Analysis of the History of Dot.com Mania from a Psychological Perspective
When talking about the dot.com bubble that happened between 1995 and 2000, it is essential to make sure that this phenomenon is analysed from a phycological perspective because precisely emotions and irrational behaviour were dominant among investors. Overall, emotional and behavioural finance concepts are incredibly significant theories that allow specialists and researchers to understand, explain and even forecast investors’ actions and market conditions. The main difference between these two paradigms is that the former finds people to be irrational and driven by conscious and unconscious emotions (Taffler, 2017), while the latter still assumes that investors can learn to be careful and rational. Entirely opposed to traditional finance theory, which views investor behaviour as based on their rational decisions, the psychology of investing is a better and more beneficial way to study the stock market.
To begin with, it is necessary to mention that the late 1990s was the period of adoption and increased use of the Internet. New technologies and opportunities they provided shocked and inspired people, and most of them decided that it was their chance to invest and make a vast profit (Cassidy, 2002). Many individuals chose to start their own and entirely online businesses, not realising that their expenses and inexperience would not be covered (Cassidy, 2002). Further, investors were too optimistic and had high hopes, allowing their excitement and desires to control them (Taffler, 2017). Due to the absence of solid valuation models and increased demand, the vast majority of internet and tech companies that help IPOs were extremely overvalued.
Last but not least, media companies also played a significant role in increasing the number of people investing their money in risky tech stocks. The media took advantage of both their influence on people’s emotions and a good understanding of the psychology of their behaviour and began to promote investment (Cassidy, 2002). Representing risky stocks as overly optimistic and guaranteeing sooner returns, they made more and more people believe them and consider the situation a once-in-a-lifetime opportunity (Taffler, 2017). Eventually, inexperienced investors failed to carefully evaluate the risks and did not prepare themselves for the burst of the bubble, which has caused severe panic and general shock (Aliber and Kindleberger, 2015). Overall, dot.com mania represented people’s unpreparedness, inexperience and irrationality when dealing with money and new technologies.
Comparing and Contrasting Present Investment Markets with Those at the Start of the Millennium
There are certain similarities and differences between the state of the current investment markets and what they were a little over twenty years ago. First of all, just as it was at the start of the millennium, many new and inexperienced investors are now entering the market (Maggiulli, 2020) (this factor will be discussed in the following sections of the paper). Further, the current bubble and the dot.com bubble are characterised by people talking about the new era of the economy and convincing themselves and others that the old rules for investing no longer apply (Maggiulli, 2020). In the early 2000s, this was due to the emergence and popularisation of the Internet, while at the moment, the coronavirus has a great influence on the situation. This is an expected behaviour studied from a psychological perspective. Finally, speculation is another similar trait of the present and previous investing market (Cassidy, 2002). It is common for people’ psychology to look for easy profit and hope to get money in a not entirely fair way without assessing the risks.
As for the differences, they include the reduced involvement of the media compared to their popularisation of investment twenty years ago. What is more, according to Maggiulli (2020, para. 4), there is a “much lower (yes, lower) growth rate of technology stocks compared to the late 1990s”. The researcher mentions that “over the past five years the Nasdaq Composite has increased in value by 127%, which pales in comparison to the 456% growth in the Nasdaq during the heyday of the dot-com era” (Maggiulli, 2020, para. 4) (Figure 1).
This factor is characterised by lower euphoria and increased disbelief of modern people. They are more cautious and begin to assess the possible risks before investing their money.
A Rerun of the Internet Bubble or a New Economic Paradigm?
Currently, an extended number of people are worried about the possibility of a new tech bubble bursting. Unfortunately, these fears are not unfounded, and researchers and investors continue to argue about whether the situation with the dot.com boom will repeat itself or it is merely a new level of the economy. Rather strong arguments support both opinions, and it is essential to discuss them in order to draw particular conclusions and be able to state whether there is a rerun of the internet bubble or a new economic paradigm.
Indicators that There Is Another Tech Bubble
To begin with, many various factors are similar to what happened at the beginning of the millennium, and they make professionals and ordinary people worry about the bubble and its further bursting. For example, in September 2020, “Tesla’s shares fell 21% and Elon Musk’s net worth plunged $16.3bn (£12.7bn)”, while “Amazon’s founder, Jeff Bezos, lost $7.9bn” (Rushe, 2020, para. 2). At the same time, since the beginning of the COVID-19 pandemic, these major tech companies have only increased in value (Rushe, 2020). Further, according to Karabell (2021, para. 2), the fact that stocks are up 80% since March 2020, “bitcoin has gone up nearly five-fold”, and “Tesla has soared almost eight times”, it is possible to suggest that there is a bubble, and it is about to burst (Figure 2). Additionally, the approximately $20 trillion spent by global governments to support economies devastated by the pandemic contribute to this suggestion.
Overall, there are some warning signs of a stock market bubble. These three necessary conditions, namely, speculation, marketability and debt and money abundance, are described by Quinn and Turner (2020). In order to try to understand the current state of the economy, it is essential to check whether these signs are present in it:
- Speculation is a unique strategy based on predicting the market’s phycology instead of focusing on fundamental principles (Quinn and Turner, 2020). In other words, people purchase assets that are expected to rise in price in the nearest future. A significant indicator of speculation is an increased number of day traders, which is also a primary characteristic of a stock market bubble. Nowadays, some share trading apps, including the UK IG and the American Robinhood, report that their levels of new sign-ups are unprecedented, while several Chinese trading apps also announce that their networks are unprepared for this level of traffic.
- Debt and money abundance is a critical condition of a bubble. According to Acharya and Naqvi (2019), in case real rates on safe assets and savings accounts are negative or almost zero, investors are encouraged to reach for yield. Therefore, the ultra-low interest rates triggered by the pandemic outbreak have lowered the discount rate, which was reflected in higher prices, and also encouraged investors to move into shares and riskier areas of the stock market (Beck et al., 2020). Consequently, it is easier for investors to speculate in the stock market by obtaining margin loans, and easy credit and low-interest rates contribute to this possibility.
- Since it is impossible for a bubble to appear if assets cannot be traded easily, marketability is an essential factor. It defines the ease with which assets are sold and bought at the moment, and the recent proliferation of fractional trading and trading apps with zero commission has increased marketability (Quinn and Turner, 2020).
Therefore, it is evident that all three warning signs are present in the current stock market, and this fact allows specialists to be worried about the occurrence and bursting of another tech bubble. Additionally, the fact that an extended number of inexperienced investors are presently entering the financial markets is another warning sign. Finally, some people believe that one of the COVID-19 pandemic’s consequences will be a new economy that will be dominated by technology companies, which is also a reason to think that there is another bubble.
Indicators that the Stock Market Is Not in a Bubble
Despite the severe conditions mentioned above, there are some factors that make it possible to suggest that things are actually different from what happened twenty years ago. To begin with, it is crucial to mention that numerous people are sceptical and insecure about this bubble mania, which in itself is the opposite of euphoria. Recently, both ordinary people and upper-income brackets have been saving their money and keeping it in cash, which most likely signifies their unwillingness to invest. According to Karabell (2021, para. 8), “an extra $2 trillion has been added to savings accounts, bringing the total to more than $5 trillion, higher than during the Great Recession in 2009”, and this is a robust sing of caution, not euphoria.
Furthermore, it is also evident that there is nothing severe to provoke the appearance of a bubble. According to Beck et al. (2020), all previous bubbles have resulted from either a new government policy or the emergence of radically modern technology. As for the current situation, “the technology shares that have driven the stock market bounce are by no means new technology – these are established companies and technologies benefiting from an increase in demand” (Beck et al., 2020, para. 19). As for a new governmental policy, it is challenging to be identified, but there was a potential threat when “central banks used unprecedented QE to arrest a stock market crash that was on a par with the historic falls in 1987 and 1720” in March 2020 (Beck et al., 2020, para. 20). However, only time will tell if that was the reason.
Conclusion
Based on all arguments mentioned above, it is possible to suggest that specialists cannot clearly say whether the stock market is currently experiencing a rerun of the internet bubble or there is merely a different economic paradigm affecting it. Some researchers say that a bubble can be detected right before or after it bursts; therefore, trying to identify it in advance is not very effective. Nevertheless, this paper finds the arguments for the presence of the bubble to be more serious and convincing, which is why it supports the opinion that the stock market is currently in a tech bubble.
State of Manic Denial
It is believed that there is a five-stage trajectory common to all financial bubbles, and it is possible to divide each historical bubble into the following periods: displacement, boom, euphoria, profit-taking and panic (Cassidy, 2002). Supposing that there is another tech bubble, it is most likely in its euphoria stage. Though some people would state that there is no bubble because current asset valuations are rather realistic, this paper attempts to prove otherwise.
To begin with, numerous specialists and researchers try to convince investors of inflated stock prices. According to Cassidy (2002), during the euphoria stage, it is common for people to be too excited and hopeful and not pay attention to the unjustified rise in asset prices. In order to prove that the current asset valuations are not realistic and there is a bubble in the market, it is essential to look at the numbers and use the price-to-earnings (P/E) ratio. For example, according to Quinn and Turner (2021, para. 17), “the S&P 500 currently has a P/E of 37, which is considered very high by historical standards”. What is more, “Tesla’s P/E is currently over 1,100, suggesting that it is spectacularly overvalued relative to its current profitability” (Quinn and Turner, 2021, para. 17).
Additionally, the behaviour of insiders and people who are very close to tech companies is quite revealing and convincing. For instance, according to the researchers, numerous technological companies are selling many of their own shares, including Tesla and Blink Charging, or use them instead of real money to pay their workers (Quinn and Turner, 2021). Therefore, the fact that insiders do not value their shares means that they are aware of their unrealistic price.
‘Phantastic Object’ Concept vs Traditional Old Economy Approach
‘Phantastic object’ is a unique term that, twenty years ago, allowed researchers to explain the unconscious appeal of dot.com stocks and later has been found to be equally useful in understanding the Global Financial Crisis. Nowadays, it may be applied to get insight into the valuations of unicorns, new listings, and internet and cloud-based stocks more generally. According to Tuckett and Taffler (2008, p. 389), “buying, holding or selling financial assets in conditions of inherent uncertainty and ambiguity, …, necessarily implies an ambivalent emotional and phantasy relationship to them”. Most unicorn and cloud-based companies are overvalued; although they have abnormally high stock prices, many of them have not generated profit. Nevertheless, people continue investing in them while disdaining more traditional old economy ‘bricks and mortar’ stocks and not realising the risks (Tuckett and Taffler, 2008). Therefore, the ‘phantastic object’ concept is also useful when explaining the current phenomenon.
Applying Emotional Finance and Behavioural Finance to Explain Current and Future Market Conditions
When the world emerges from the Covid-19 pandemic, there will be inevitable consequences and factors affecting the stock market. When looking from emotional finance and behavioural finance, it is possible to suggest that people will be investing in those industries that have been the best at surviving the pandemic. In this way, they will feel more secured, which is necessary for them after the coronavirus and explained by emotional finance theory (Taffler, 2017). It is also likely that, as behavioural finance believes, investors will be more rational in making decisions. What is more, since the occurrence of new strains of the COVID-19 will threaten people, many investors are expected to save cash and invest less.
Emotional Finance vs Behavioural Finance: Understanding the Psychology of Present Market Valuations
While both emotional finance and behavioural finance are based on the idea that unconscious processes drive people’s investment decisions, there is a crucial difference between the two theories. Compared with the former, behavioural finance also believes that some people may become rational in evaluating potential gains or losses (Keswani, 2019). As mentioned above, present market valuations are growing, and it is not always possible for companies to justify their stocks’ prices. According to emotional finance, people driven only by emotion continue purchasing shares because they cannot be rational. However, as behavioural finance indicates, some begin to save their money as the sense of reality begins to invade their minds (Keswani, 2019). Thus, they will prevent their emotions from controlling their decision making.
Conclusion
To draw a conclusion, one may say that stock market bubbles are extremely difficult to predict, especially when almost every specialist and investor try to spot them. When a bubble eventually bursts, it is necessary to analyse its causes and people’s behaviour from a psychological perspective. Compared with traditional normative finance theory, behavioural and emotional finance find investors’ actions based on their emotions and irrationality, which is a more realistic approach. Admitting that people’s excitement, fears, hopes and desires motivate them to buy or not buy shares is an important step in studying investor behaviour.
Reference List
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