From dot-com to AI: Lessons from stock market bubbles

The word ‘bubble’ in investing carries heavy weight. It can bring great profits for some but devastating losses for others. A stock market bubble lures investors with promises of huge gains, but underneath this appealing surface, prices become disconnected from reality.

Think back to the dot-com craze of the late 1990s when internet stock prices skyrocketed to unrealistic levels before crashing down spectacularly. Or recall the more recent housing bubble that burst with catastrophic consequences during the 2008 global financial crisis. This is a stark warning about the dangers of irrational exuberance.

In this article, we’re going to explore the history of market bubbles. We’ll dive into how greed and too much confidence have caused financial disasters before. By looking back at past bubbles, we can learn important lessons and how we can avoid getting caught in the next market bubble that inevitably comes along.

1990s dot-com bubble

In the late 1990s, investor mania over internet and technology companies fueled a speculative frenzy in the stock market known as the dot-com bubble. These companies, many of which were little more than ambitious ideas scribbled on the back of a napkin, saw their stock prices skyrocket to stratospheric levels fueled by sheer speculation and the belief that the internet would revolutionise the world as we knew it.

Investors threw caution to the wind, piling into dot-com stocks for fear of missing out on the next big thing. Traditional valuation metrics like price-to-earnings ratios were disregarded as share prices became wildly disconnected from reality. The market reached peak euphoria around 2000 when the S&P 500 reached a P/E ratio of 44.19; while The Nasdaq index reached a record high of 44.2, nearly triple the average since 1971.

This unbridled optimism created an atmosphere where even companies with just a basic website idea could quickly raise millions from eager venture capitalists. Overnight millionaires abounded amid the mania for all things dot-com-related.

However, this bubble was destined to burst. When reality finally caught up with these overvalued and overextended companies, the Nasdaq index crashed nearly 80% from its peak as investors finally recognised most dot-coms had no real viable business models. Billions in paper wealth evaporated in a matter of months as valuations returned to earth.

The dot-com craze demonstrated the risks of investment manias driven by speculative frenzies untethered to fundamentals. It serves as a notorious example of the need for prudent risk management instead of blindly following asset bubbles fueled by hype and greed.

2008 subprime mortgage crisis

The subprime mortgage crisis was a catastrophic financial meltdown caused by reckless lending practices and excessive risk-taking by banks and Wall Street firms.

In the years leading up to 2008, lenders aggressively approved risky mortgages to borrowers with poor credit and little ability to repay the loans. These subprime mortgages were packaged into complex mortgage-backed securities and sold to investors under the guise of being safe investments despite lax underwriting standards. Along with the housing market, the S&P 500 reached a peak P/E of 123(!), significantly higher than the historical average.

When the housing market turned, and mortgage defaults surged, it exposed these mortgage securities as toxic assets filled with bad loans. This poisoned the balance sheets of major banks and financial firms that had leveraged themselves excessively. What was initially praised as financial innovation was revealed to be a house of cards built on unsustainable risk and regulatory shortcomings. Markets panicked, credit froze up, and the crisis triggered a severe global recession as businesses struggled and unemployment spiked.

The subprime crisis underscored the dangers of unchecked greed on Wall Street, where profits were put ahead of prudent risk management. It highlighted the need for regulatory reforms and more responsible lending standards to prevent a similar catastrophe from occurring again due to reckless behaviours.

Ultimately, the subprime meltdown is a harsh reminder that excessive risk-taking, opaque financial instruments, and focus on short-term gains can have devastating systemic consequences when bubbles inevitably burst.

2021 Post-COVID Bubble                                                     

In the wake of the unprecedented global pandemic that brought economies to a grinding halt, central banks and governments worldwide took extraordinary measures to mitigate the economic fallout.

Central banks, such as the Federal Reserve and the European Central Bank, injected unprecedented liquidity into markets through massive bond-buying programs and near-zero interest rates. These actions aimed to provide a much-needed lifeline to businesses and households, ensure the continued flow of credit and prevent a complete economic collapse. While necessary to address the immediate crisis, this deluge of cheap money and fiscal support had an unintended consequence: the inflation of asset prices to potentially unsustainable levels.

With interest rates at historic lows and a glut of liquidity sloshing around the financial system, investors sought higher returns, fueling a frenzy in various asset classes. From stocks and real estate to cryptocurrencies and non-fungible tokens (NFTs), asset prices soared to dizzying heights, seemingly disconnected from underlying fundamentals. At its peak, the S&P 500 reached a P/E of 39 in December 2020, just months after the market bottom in March 2020.

While the unprecedented nature of the COVID-19 pandemic and the subsequent policy responses may have created unique circumstances, the underlying human tendencies toward overconfidence and herd behaviour remain unchanged. A prime example of this is the ARK Innovation ETF which invests in disruptive companies across various sectors. In February 2021, the ARK Innovation ETF reached its peak, trading at over US$156 per unit, before experiencing a crash of over 80% by December 2022.

2024 AI bubble?

The fervor surrounding the advancements in artificial intelligence (AI) has led to a significant influx of capital, skyrocketing valuations of AI-related companies, and a general sense of euphoria about the technology’s potential to revolutionize every aspect of human life. This craze is underpinned by legitimate and groundbreaking innovations in AI, including developments in generative AI, natural language processing, and machine learning algorithms, which have demonstrated applications that range from improving medical diagnostics to optimizing supply chain logistics and transforming customer service. The promise of AI to drive efficiency, unlock new markets, and solve complex problems supports the argument that the current interest in AI is more than just hype—it’s a recognition of a transformative technological shift akin to the advent of the internet.

However, the characteristics of a bubble are present in the current AI boom. The rush to invest in anything AI-related has led to inflated valuations, with startups and established companies alike receiving generous funding rounds based on future potential rather than current earnings or proven business models. This speculative investment is reminiscent of past bubbles, where the fear of missing out (FOMO) drove prices to unsustainable levels, detached from economic fundamentals. Additionally, there’s a proliferation of companies branding themselves with AI, sometimes superficially, to capitalize on investor enthusiasm, which could dilute the market with ventures that lack the capability to deliver on their ambitious AI promises.

The key question is whether the market can discern between genuine value creation and speculative excess. Some projects and companies will inevitably fail to live up to their lofty valuations, leading to corrections. However, those that do harness AI effectively could drive significant economic growth and innovation.

The fifth perspective

The dot-com bubble, the subprime mortgage crisis, and the post-COVID bubble phenomenon may have occurred in different eras and across different sectors of the economy. Still, they share a troubling common thread – a disregard for fundamental valuation principles, a fixation on short-term gains at the expense of long-term sustainability, and a collective euphoria that blinds market participants to underlying risks.

During these periods of market exuberance, traditional metrics for assessing the intrinsic value of assets were cast aside in favour of speculative enthusiasm and the belief that ‘this time is different.’ Valuations became detached from economic realities, driven instead by the fear of missing out on the next big thing and the allure of effortless riches.

However, as history has repeatedly shown, these bubbles are unsustainable, and their eventual bursting is inevitable and devastating. When reality finally catches up and the euphoria dissipates, the consequences are severe and far-reaching. The dot-com crash, the subprime mortgage meltdown, and the potential unwinding of the post-COVID bubble are stark reminders of the perils of unchecked speculation and the importance of adhering to sound investment principles.

Ultimately, these bubbles remind us that while markets can be subject to periods of euphoria and excess, they are ultimately governed by economic realities and the immutable laws of supply and demand. Ignoring these principles in pursuit of easy riches is a surefire path to financial ruin, both on an individual and systemic level.

By heeding the lessons of these past bubbles, we can cultivate a more rational and sustainable approach to investing, prioritising responsible risk management, transparency, and a commitment to long-term value creation over speculative frenzies driven by greed and hubris.