Oct 14, 2019

Thousands of fraud cases resulting in the imprisonments of yesterday’s top managers, dozens of suicides, $5 trillion in losses for the global economy – these are the most terrifying after-effects of the dot-com crisis. From 2000 to 2004, up to 50% of hi-tech companies went bankrupt. Twenty years ago, the world market was obviously overheating, so a financial crisis in the IT sphere was only a matter of time. Even now, some economic features indicate that stocks of such startups as Uber, Spotify, Lyft, and other IT unicorns are highly overrated.

In this article, we are going to analyze the state of the hi-tech companies global market in 2000 to figure out why the dot-com crisis was unavoidable. Then, we will consider the current macroeconomic indicators of the IT sector and predict how far we are from the next crisis. 

However, to begin with, let’s see how economic bubbles form in general.

Kondratiev waves, cheap money, and incompetence

As a matter of fact, nobody knows when and why an economic bubble would appear. After all, crises that have affected the state of the world economy have been few: from tulip mania in the 17th century to the collapse of the stock market in 2008, only five global bubbles have burst. This is a big part of why we can analyze economic shocks only retrospectively, and mathematical models created for identifying bubbles have not been tested yet.

In general, economists identify 5 phases of the economic cycle which usually culminate in a crisis.

  1. The introduction of innovations develops high expectations among investors.
  2. The investors, in turn, start investing money (borrowed, in many cases), in new technologies. This is how what we call a boom is formed. During this period, asset prices increase, not least because of the level of credit expansion. Over the course of time, stock value starts increasing more rapidly than the fundamental factors of productivity, while the investors’ returns become significantly higher than those they will see in the long run.
  3. The next phase after the boom is euphoria. Business angels buy large amount of shares in companies to resell them at a higher price. From this moment on, volatility in the financial markets begins to increase, and the value of companies can grow by tens of percent per month.
  4. Eventually, when it becomes clear that the market is overheating, those investors who are more informed start selling the shares hoping to bank the profits. As a rule, these shares are bought by less informed companies and individuals who want to maximize their profits. Therefore, for a short time, the market enjoys equilibrium.
  5. As soon as sellers outnumber those who want to buy revalued assets, panic sets in. The investors sell these toxic assets at lower prices, and, due to margin calls, a domino effect arises – the market falls.

This is a typical scenario for every economic crisis. However, we don’t know what exactly the trigger is for the formation of each particular economic bubble. Still, today there are several theories that can explain the nature of crises and help us predict upcoming shocks.

One of the promising theories that explains the causes of crises is associated with Kondratiev waves. According to scientists, economic bubbles can form on the Kondratiev upward wave when a technological paradigm changes. During this period, the effectiveness of existing technologies begins to decline, but investors react to unreasonable asset value too late, as they prefer investing in proven technologies that are common within the current technological paradigm.

It is believed that only five technological paradigms have ever existed, and a sixth one is about to be established.

The first technological paradigm came into existence in the 1770s, when Richard Arkwright developed a spinning frame known as the water frame, which launched the industrial revolution and marked the transition from hand production methods to machines. As a result, the world economy grew until 1814, when an overproduction crisis happened, and due to a large number of speculative investments, two stock market crashes occurred in 1825 and 1837. From that moment, the key indicators of the world economy continuously decreased until 1843. 

In 1843, following the spread of steam engines, which became the driver for the development of transport in general and railways in particular, the world pulled out of recession – the second technological paradigm came into existence. The UK, the USA, Germany, France, and Belgium became industry leaders – the GDP of these countries grew by tens of percent. However, this could not last forever – the next Kondratiev wave reached its peak by the 1870s, followed by the Long Depression. The Long Depression began on May 8, 1873. On that day, there was panic on the Vienna Stock Exchange because investors began to fear the emergence of an economic bubble after the financial boom in Europe.

Widespread production of electricity, the discovery of cheap methods for steel and explosive production, and the invention of the internal combustion engine kick-started a new Kondratiev wave and the third technological paradigm. As a result, for the first 30 years of the 20th century, telecommunication appeared, people became more mobile, production was cheaper than ever before. However, on October 29, 1929 there was another stock market crash, this time in Wall Street. The key factor of the crash was that money supply was disproportionate to production – people simply didn’t have enough money to purchase such a large number of cars, radio sets, commercial appliances. This caused deflation which eventually crashed the stock market in the USA, and then in other developed countries. In this way, industrial production fell to the level of 1900; at least 30 million people became unemployed, and many stopped believing in capitalism and began to develop communist and fascist ideas. Specifically, the National Socialist German Workers’ Party appeared at that time.

On August 2, 1939, the first jet aircraft hit the skies in Germany, and three years later, the USSR developed ballistic missiles. Also, during WWII, Alan Turing invented the machine for cryptanalysis – the prototype of today’s computers. All these factors became key for the formation of the fourth technological paradigm and the growth of the next long wave. However, over the course of time, the effect of break-through technologies faded away, and world economic growth began to slow down. The US Balance of Payment deficit had reached $49.5 billion by 1971, and the UK was in a major depression too. The result of these events was serious dollar devaluation and the crisis of the Bretton Woods system. Millions of people were unemployed again.

In the 1980s, due to the development of electronics and computer technology, investment activity began to bounce back. Microsoft bought DOS operating system, and Steve Jobs introduced his first personal computer to the world. From 1983, the world economy started recovering from the crisis, and the gross income of the European countries and the USA began to increase sharply – the fifth technological paradigm was formed. Positive changes were not affected by the dot-com crisis (discussed below) much, and some regions were not affected at all. Nevertheless, huge amounts of cheap money accessible for both institutional investors and individuals, imbalances in international trade, and overheating of the mortgage market couldn’t help leading to a global financial crisis that can be compared with the Great Depression. It is acknowledged that the recession’s consequences in different regions of the world were resolved in the 2010-2018 period.

Consequences of the 2008 crisis (The darker the red, the stronger the decline in GDP).

According to economists, we are now experiencing the emergence of the sixth technological paradigm, the main driving force of which will be NBIC convergence, or the merger of nano, bio, information, and cognitive technologies. Many scientists think that this Kondratiev cycle will be the shortest one, and the next technological paradigm will have exhausted its potential by the 2040s. Thus, nobody has any doubts that one day, the next financial crisis will come. The only question is when it will happen, and what role the IT market will play there. Indeed, 20 years ago, the IT companies were already in the heart of the bubble, the burst of which led to serious consequences.

Dot-com bubble

In the period of 1995 to 2000, the global economy grew faster than ever before amid the universal development of the Internet. Hundreds of American and European economists, including Nobel Prize nominees, claimed that the new economy was coming, and the Internet companies could generate enormous profits. However, these ambitious forecasts didn’t come true, and loan assets, spent by investors on the Internet companies, turned into seven-figure debts, which led to a sharp decrease of NASDAQ index and computer server price collapse.

Nevertheless, many company owners managed to make money. From the beginning of 1998 to February 2000, the profits of the Internet sector increased by 1000%. In fact, at its peak, dot-com stocks exceeded 20% of the aggregate price of all traded stocks in the world. Thus, it’s not surprising that in 1999, about 150 companies in the United States added dot-com to their names. Subsequently, 10 days before the crash, the excess return on shares of such companies amounted to 74% on average.

The NASDAQ index also grew extremely sharply – from 1,000 points in 1995 to over 5,000 points in 2000. When the Internet companies went to IPOs, their stock prices sometimes doubled by the end of the first day of trading. Due to this, even those companies which were totally unconnected with high technology, apart from the word dot-com in their advertising booklets, began to attract capital. 

The boom ended on March 10, 2000, with a NASDAQ crash. And by the end of May, the index had fallen to 3500 points, which is equivalent to a loss of one trillion dollars for the global economy.

Private investors suffered the most during this period. When companies went IPO, their employees were forbidden to carry out any operations with shares, usually for a period of 90 to 180 days (blocking period). However, understanding the real cost of the companies, employees intended to sell the shares as soon as the blocking period was over. Realizing the root motives of such behavior, institutional investors sold shares after the manner of the Internet companies’ employees. And all these shares were purchased mainly by private investors who didn’t have the possibility of analyzing the situation on the high-tech market and seeing that, in fact, they cost pretty much nothing. 

NASDAQ index dynamics during the dot-com boom

The current state of the high-tech market

Analyzing the modern economy, scientists agree that the key financial lever that always launches the next bubble is the increase of the money supply and the lending limits. Today, the money supply on the high-tech startup market is growing significantly and far exceeds demand.

Venture capital

At the end of 2018, the venture capital of the USA exceeded $130 million, which is 30% more than in the dot-com era. This is one of the reasons why recently IT companies avoid IPO and rely on private sources of financing. However, unlike 2000, when companies decide to place their shares in NASDAQ, these shares are valued, except in rare circumstances, in accordance with the investors’ expectations. 

Compare: from 1998 to March 2000, the number of underpricings grew at an exponential rate, and shares’ costs often increased by 50% or more after the first day of trading! But now, the underpricing occurs relatively rarely, and an increase in the cost of the high-tech companies’ shares by 20% on the first day of trading is normal and associated with the asymmetry of information on the brink of an IPO.

Return on investment in IT

Another eloquent indicator of the market state is the ratio of price to earnings per share (PE). However, due to different accounting approaches, it is difficult to compare the companies’ profits. 

The solution to this problem in the form of the cyclically adjusted price-earnings ratio (CAPE ratio) was suggested by economist Robert Shiller. Although the CAPE ratio was originally created in order to reveal consistent patterns between stock prices and their returns over the next 10 years, scientists noticed that this indicator strongly correlates with periods of economic booms and downturns in business activity.

On the graph below, the dashed line shows the average number of IPOs over a six-year period, and the solid one reflects the CAPE coefficient.

As we can see from this graph, the previous economic crises occurred when the CAPE coefficient was above 27.

Today, for the high-tech sector, CAPE exceeds 35. This index is very close to the ratio of prices and earnings per share in 2000.

Nevertheless, the current level of CAPE does not mean you should sell your Facebook shares as soon as possible. After all, this index is a technical indicator of the economic state and signals that in the near future the earnings per share of companies from the IT sector are likely to decline. However, it doesn’t mean that we are in a bubble that is about to burst. It is likely that at the present stage, companies from the NASDAQ index really work more efficiently than ever. Or not. Nobody knows for sure except the owners of these companies.

Market volatility

An attractive level of stock returns and a sufficient amount of cheap money leads to increased trading volumes in the financial markets. And increased activity, in turn, is reflected in increased volatility. 

In order to understand how markets behave right before crises, let’s compare the volatility of NASDAQ and S&P500 in the graph below. In March 2000, when dozens of Internet companies went to IPOs daily, and nobody understood how much they would cost, the NASDAQ volatility reached 80.5 points. A month before Lehman Brothers went bankrupt and directly afterwards, the situation developed similarly among the companies with the largest capitalization in the world. But now, the NASDAQ volatility does not exceed 14 points, which is even lower than in 2014 and 2015.

Demand for programmers

During the dot-com boom, the demand for web developers in different regions of the world grew by 1000% or more. And according to Hired, in 2018, when the Bitcoin bubble inflated, and many began to be interested in blockchain, blockchain programmers became 517% more popular.

Evans Data Corporation analysts estimate that between 2017 and 2019, the global developer market grew by 45%, and now there are about 24 million software engineers in the world. Nevertheless, the demand for labor from IT companies is still much higher than the supply. That’s why the expectations of Goldman Sachs analysts, who predict that India alone will offer about 110 million developers in the next 10 years, are not surprising.

According to the US Bureau of Labor Statistics, the demand for programmer services will grow even faster than supply (on average, 17% annually over the next decade). However, the structure of demand will change significantly, and those who develop in such popular languages as, for example, Java or .Net, should worry about their future.

Jeff Hammond, director of Forrester Research, is not alone in claiming that the spread of containers, low-code platforms, and serverless technologies will make programming much more abstract than it is now. Besides, due to the development of AR and VR, there will be a growing demand for those who are able to create augmented and virtual reality applications almost unaided. The skills necessary for processing and synthesizing human speech will also be in demand, and data analysis will be a basic requirement for developers.

Major changes are also expected in the B2B high-tech market. By 2030, the demand for development as a full-cycle service will have significantly increased – first of all, ready-made development teams will be in demand, while the need for individual programmers will have decreased. At the same time, according to Forbes, the main software customers will be automobile companies, as well as advertising and payment services. Complex services for the development of embedded systems will also have increased in price.

Demand for software services is expected to increase until around 2040, which correlates with forecasts for the development of the sixth technological paradigm. However, the programming process is already becoming less and less painstaking, and interpreters and compilers have made the lives of developers much simpler than 20 years ago. It is likely that the spread of Artificial Intelligence, as well as the emergence of new programming languages that allow the literal construction of applications, will, in the end, devalue the work of those who we consider developers today.

In order to understand how this is possible, it is enough to look back about 100 years. One of the best-paid professions in the mid-19th century was the profession of the telegraph operator. The telegraph operators were one of the most technically savvy specialists of that time – their work was expensive, and they had an almost unlimited freedom to travel. Almost every year, new communication standards appeared, and telegraph operators had to learn them constantly in order to keep up with the market requirements. However, by the beginning of the 20th century, a much more advanced technology than the telegraph had appeared – a telephone. The need to translate Morse code into natural language abruptly disappeared. By 1920, only a few telegraph operators were left, and the most severe financial crisis in world history would follow. Why would this story not be repeated with programmers? We have no answer to this question.

All we know for sure is that if the world is experiencing the bubble that is forming in the IT market, then it is in its very initial phase. In the next 10 years, high technologies will be more in demand than ever, and the demand for programmers’ services will grow rapidly. This will continue until a new, more advanced technology comes to replace programming in its current sense. As a result, millions of people will again be left without work for many years, and the world will face another protracted recession – the purpose of which is the start of the next race for the growth of financial well-being, but under new conditions, and the name of this is the seventh technological paradigm.

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