Stock Market, Media, and the 1990s Tech Bubble Collapse

Introduction: Qualitative and Quantitative Forces in Stock Trading

The world of stock trading at first gives the impression of a hardcore science. Prediction of stock movement is based on a complex series of formulas, algorithms, and mathematical predictive models. These portions of stock trading represent the quantitative element of the stock world. However, there is also a qualitative side to stock trading that is often not addressed via traditional stock trading metrics. The world of finance is reactive to major world events and other conditions such as consumer demand. Prior to the great tech stock crash of the late 1990s, tech companies attempted to make a profit based on trends in consumer demand. This paper analyzes two companies that used unethical practices during the tech stock bubble and examines what investors can do to protect themselves from similar failures.

The Rise and Fall of the Tech Sector

The rise of the Internet meant the founding — and sometimes quick downfall — of Internet-based companies. Many companies increased their stock price by simply adding the prefix "e" to their name (Galbraith & Hale, 2004). Rapid rises in stock prices caused a type of "flocking" effect among traders. When a stock price rose, even if the rise was unfounded in solid metrics, it enticed others to buy the stock in hopes of fast money. This created a "bubble" in tech sector stock prices. However, like a bubble, these rises in stock price were fragile because they had no basis in solid financial management of the company. The stocks were overvalued, and many of them declined as quickly as they rose.

Dot-com business theory was based on the idea that profits were best obtained by expanding one's customer base as quickly as possible, even when this would produce large debt or annual losses. Some of today's giants, such as Google and Amazon, survived using this strategy to become some of the largest Internet companies after the bubble burst. However, many companies did not survive. At the beginning of the bubble, any dot-com that looked promising could make an initial public offering (IPO) to raise capital, even if it had never shown a profit in the past. The company's lifespan was measured by how quickly it used up its initial capital in expanding its customer base. The customers had to come — and come quickly — or the dot-com was doomed to fail as soon as its capital ran out. This was not a viable business model, and many companies resorted to unscrupulous means to fool stock investors into purchasing their stock. The primary tactic was to utilize a public awareness campaign using the largest mass media platforms available. The following two case studies examine companies that used this strategy to fool investors by placing growth over profits and a solid financial foundation.

Nortel: Expanding Too Fast

Nortel (stock symbol NT) is an excellent example of a company that had a solid foundation in the "old economy" but that switched to the "new" rapid-growth business model and used unscrupulous methods to cover up its mistakes. The foundations of Nortel go back to 1895, when it began as Northern Electric & Manufacturing (Nortel-Canada.com, 2012). Nortel was an infrastructure provider, and when the dot-com boom began, speculators anticipated that demand for Nortel's products and services would soar. They were right, and by the 1990s Nortel was one of the largest providers of infrastructure for Internet services.

Nortel executives underwent a lengthy court trial to defend themselves against accusations that they fraudulently inflated profits to create a rise in stock price in order to fund needed infrastructure expansions. After the dot-com crash, it was further alleged that executives continued to use fraudulent accounting practices to shield their company from stock price drops. Inflated forecasts drove stock prices upward. At the same time, Nortel executives enjoyed an extravagant lifestyle at the expense of employee retirement accounts and benefits (Austin, 2012). Eventually, these business practices became unsustainable. After accusations emerged that executives had faked profits and minimized losses in the books, the long downfall of Nortel began. The issues arose shortly after the turn of the century and continued through the legal dissolution of the company.

Conclusion

The most important lesson drawn from the dot-com era is to avoid "flocking" with the crowd and instead make solid investing decisions based on metrics and the real value of the company. Herd behavior in financial markets amplified both the inflation and the collapse of tech sector valuations during this period. Keeping sound analytical principles in mind — whether one is an individual investor or a multinational corporation — is the best way to invest in companies that will still be standing when the next bubble bursts.

References

Austin, I. (2012). Ex-Nortel executives' fraud trial to begin. The New York Times, January 15, 2012.

Galbraith, J., & Hale, T. (2004). Income distribution and the information technology bubble. University of Texas Inequality Project Working Paper.

Kawamoto, D. (1999). Webvan's shares sink after IPO frenzy. CNET, November 16, 1999.

Nortel-Canada.com. (2012). History of Nortel.

Zito, K. (2001). Webvan puts brakes on expansion: Online grocer delays East Coast expansion plans as losses mount. SF Gate, January 26, 2001.