The collapse had been foreseen by a shrewd few. In early December 1996, Alan Greenspan, the Chairman of the US Federal Reserve, attended a dinner in his honor at the American Enterprise Institute. After the guests had finished eating, Greenspan rose to make a long speech on the Challenge of Central Banking in a Democratic Society. In the last few paragraphs of his speech, Greenspan injected words of caution. He accepted that sustained low inflation and lower risk premiums were driving up stock prices. Yet at the same time, he noted the growing distance between investors’ expectation returns from stock and how much those stocks were actually earning. Greenspan asked:
…how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?
With spectacular IPOs such as Netscape’s in 1995 being eclipsed by the seven fold one day leap during the VA Linux Systems IPO in 1999, it was a reasonable bet that investor expectations had grown to be several multiples of probable returns. Greenspan’s warning about irrational exuberance was forgotten as stocks continued to soar. In early 2001, as the NASDAQ faltered, Warren Buffet made clear his belief that the exuberance had been irrational:
Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities – that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future – will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.
On the other hand, there was perhaps a kernel of rationality driving the dot com fiasco, much as there had been some logic to the tulip bubble. The most highly valued patterned tulips were necessarily rare. They grew only from bulbs infected with the mosaic virus. The virus caused their colorful, patterned flowers but it also reduced their capacity to reproduce. Thus infected bulbs were most in demand for their beauty and rarest because of the virus. Not only were they in demand in the Netherlands, but in cities like Paris also, where the elite were enthusiastic consumers. The follies of the dot com era too had mitigating factors. It was true that those who moved quickly with good ideas had spectacular successes. Amazon, for example, had beaten Barnes & Noble, the high street retail giant, by becoming the dominant bookseller on the Internet before Barnes & Noble had awoken to the Internet. Similarly, eBay, by dominating the market for online auctions earliest, had been able to forestall Amazon’s entry into online auctioneering.
It was eBay that provided the most dazzling example to investors mulling over the balance between profit and risk in the new dot com world. It had started life as ‘AuctionWeb’ on 4 September 1995. By the end of 1996 41,000 users had traded $7.2 million worth of goods on eBay. In 1997 (when eBay officially became eBay rather than AuctionWeb), 341,000 users traded goods worth $95 million. By the end of 1998, eBay’s gross merchandise volume had reached $740 million, and registered users had hit 2.1 million. The figures continued to rise: reaching $2.8 billion and 10 million registered users by the end of 1999 and $5.4 billion and 22 million users by the end of 2000. In 2001, despite the dot com collapse, $9.3 billion worth of goods were traded by 42 million registered users. The mindboggling growth continued thereafter: in 2002, $14.9 billion, and 62 million users; 2003, $23.8 billion and 95 million users; 2004, $34.3 billion, 135 million users; 2005, $44.3 billion, 181 million users; 2006, $52.5 billion, 222 million users. By 2007, the total value of sold items on eBay’s trading platforms was nearly $60 billion. eBay users across the globe were trading more than $1,900 worth of goods on the site every second. Reading statistics like these, one could more readily bet significant quantities of capital on startups less far-fetched than eBay had been.
Spotting and acting on opportunities before one’s competitors became increasingly important. Whereas in the pre-dot com era a company had required a minimum of four quarters of profitability to attract funding, these rules were forgotten in the dot com frenzy. Some investors were new comers who had never known the rules to begin with: Goldie Hawn had established her own startup and an investment group called Champion Ventures was established for retired athletes by former 49ers players. Investment decisions that normally would have taken a minimum of a period of weeks were now taken over the course of a telephone call. The CEO of one startup recalls:
I made a call to a friend of mine, Ron Conway of Angel Investors, and he jumped on it immediately. The next morning we had our money—the $700,000 seed money.
With no time for careful analysis and a bullish investment culture, word of mouth within the tightly knit financing community of the Valley began to carry the weight of authority. Prominent investors who valued each others’ opinions or felt a duty to back each others’ investments lent a momentum to individual decisions, good or bad. In 1999 venture capital investments reached their historic peak of $48.3 billion. Rationality, in Buffet’s words, had been given its sedative dose.