Anatomy of a Tech Bubble

It seems as though overvalued Internet stocks are a bit like horror movies for investors… they’re always followed by a sequel. At least that’s what those in the “Bubble 2.0” crowd think.

The belief here is that the same sequence of events that fueled the first dot com bubble is reoccurring now; that the new class of Internet IPOs, from Linkedin, Pandora and Zillow plus the upcoming Groupon and Zynga offerings, and the massive $100 billion valuation of Facebook, are stirring a mania that will result in a market crash like the horror story of 2000-2002.

But before we paint the current market euphoria with the same brush, let’s first identify the causes of the last technology bubble, and then check to see if the same forces are back at work. If so, Bubble 2.0 may be here.

A list of causes of Bubble 1.0 include:

Some economists maintain that a central bank’s monetary policy — the means by which the supply of money and credit are regulated in an economy — are the primary drivers of bubbles. One such economist, Bill Fleckenstein, accused former Federal Reserve Chairman Alan Greenspan of pursuing an inflationary monetary policy; in other words, a policy of creating more money. This newly created money finds its way into markets and inflates prices while distorting the price discovery process overall.

Widespread fraud

Another key element that drove Bubble 1.0 was fraud. The SEC investigated a wide array of crimes, the most significant of which was purchase of analyst recommendations, in which companies paid analysts to recommend stocks to their customers.

Manic Speculation

The dot com bubble brought with it a new industry of budding daytraders; investing for the long haul was out, and short-term trading for income was in. Brokers profited from the boom in daytrading, but when the crash came, the party ended unceremoniously.

Deja vu?

Two Internet pundits — entrepreneur and college lecturer Steve Blank and venture capitalist Ben Horowitz, recently debated in the Economist whether we are once again headed for a 1999-style Internet bubble.

Blank cited the rising valuations in pre-IPO funding as evidence of new money, and noted how entrepreneurs and investors were exiting positions before the IPO market as evidence of a bubble. Meanwhile, the U.S. Federal Reserve’s reported increases in money supply, as well as the venture capital industry’s increased funding of social networking companies, support the monetarist view that the necessary infusion of capital needed to create a bubble has occurred.

But what about fraud? Analysts are much more regulated today and work under much closer scrutiny in the wake of Bubble 1.0. But it’s not all smooth sailing on the way to the stock market. Groupon’s accounting methods have attracted the attention of the SEC, delaying the IPO and perhaps raising some concern among investors that we’re seeing a return to the “financial gymnastics” of the late 1990s.

Back at the Economist, Horowitz, who argued against evidence of a new bubble, cited a low P/E ratio (price-to-earnings or share price divided by earnings, a metric to determine the relativity of share price to a company’s earnings) in the technology industry. During the dot com bubble, the average of the S&P 500’s P/E ratio was over 40; now it is just at 23, and major technology companies like Apple and Google are even lower.

Horowitz suggests that a low P/E ratio is evidence of a lack of manic investing, and the fact that many of these companies — like LinkedIn and Zynga — are bringing in real cash — justify the higher valuation they are receiving.

From this perspective, there is no archetypal image of a grandmother losing her home after failed adventures in daytrading from her laptop; rather, there are simply savvy investors with the industry expertise needed to properly and rationally value such firms.