Pain of Nasdaq free fall lingers

Lesson: After reaching record highs in 2000, technology stocks tumbled rapidly. Many investors remain wary of them today.

Retrospective

March 09, 2005|By Andrew Countryman | Andrew Countryman,CHICAGO TRIBUNE

When Jeff Ryan thinks back to the days of the tech stock mania, he remembers a couple who owned a carpet business being interviewed on television.

They had their savings invested in technology stocks. Asked why they selected one of the companies in their portfolio, they responded that they didn't know what it did but liked the name, said Ryan, a senior research analyst at the Charles Schwab investment firm.

"You just knew at that point that something was wrong," Ryan said. "That's not a sound foundation for buying stocks."

In those heady days, faith often trumped reason. Clicks and eyeballs mattered, not revenue and profit; day traders abounded; and everyone was going to be a tech stock millionaire.

The bubble burst, as bubbles inevitably do, and that era ended with a thud, billions in losses and countless shattered dreams.

Today is the fifth anniversary of the Nasdaq composite index's first, euphoric close above 5,000, and tomorrow marks five years since it reached its all-time closing high of 5,048.62.

After that, the Nasdaq bubble exploded spectacularly, though not all at once. Four months after the peak, the index was still trading at just under 4,300. But the bottom quickly fell out, and a year after the record close, it was down 59 percent at just over 2,050.

When it struck bottom on Oct. 9, 2002, at 1,114.11, the Nasdaq had lost 78 percent of its value. It has recovered 86 percent since, but its close of 2,073.55 yesterday leaves it almost 60 percent below the record.

Blue chips have not fared as badly.

After the Dow Jones industrial average hit its record high close of nearly 11,723 in January 2000, it fell nearly 38 percent to its subsequent low, but it has been pushing back toward 11,000 of late. Yesterday's close of 10,912.62 is 7 percent below its all-time high.

Under the circumstances, it's probably no surprise that many investors are wary of tech stocks.

"I would like to believe they have gotten gun-shy to the extent that people have been burned by that," Ryan said. "I think that they may be more cautious about jumping back into equities."

Although tech stocks have had a strong run since hitting bottom, David Joy, capital markets strategist for American Express Financial Advisors, doesn't think investors have forgotten the pain of the bubble.

"I really think that the lessons have lingered," he said. "I don't think enough time has gone by for us to unlearn all these lessons yet."

The principal one, Joy and others say, is that stock valuations matter, even with a roaring economy and the changes brought by the Internet.

"We knew we were on to something big. But we didn't know who the winners and losers were going to be," Joy said.

"I don't blame investors for looking in these directions at the time. But what they maybe could be blamed for was suspending the time-honored rules of valuation."

Ryan said the idea that the Internet changed everything had a powerful effect on investors.

"Part of it was this optimism that accompanies any technology as it becomes widely adopted," he said. "You heard way too many people talk about that as if it changed the idea that cash is cash. It didn't."

Why technology investors allowed themselves to get into this mess in the first place is still debated, although it is hard to recognize a bubble until it bursts.

DePaul University professor Werner De Bondt, an expert in behavioral finance and asset bubbles, identifies characteristics of individual investors that might help explain why they were susceptible to the tech stock frenzy.

His research suggests that investors expect past price changes to continue, have a bias toward optimism and overconfidence, and persevere in their attitudes, filtering information to conform to what they believe.

Such characteristics tend to take hold, he said, after a development that justifies a certain amount of optimism, but they are followed by a rush of relatively unsophisticated investors into the market, which is a sign that the bubble might be peaking.

"Once the market takes off, it typically pulls in millions of new investors," he said. "There's a very big herd mentality at the end."

Other experts point to that follow-the-pack mentality - when rising prices lead to more demand and, therefore, rising prices - as a crucial factor in inflating the bubble.

"We can sometimes delude ourselves into thinking things are different this time ... and you get carried away," Joy said. "You just kept seeing prices rise, and no one wanted to be left behind."

Why the bubble burst is an open question. There's no single dramatic, market-altering event to point to, experts said.

"I think that's a tough question. That's what everyone wants to know," De Bondt said. "To literally pinpoint it, that would be fantastic, obviously."

Experts wonder whether, even though prices collapsed, it a true bubble.

"The word bubble is used so loosely by people," said Ellen McGrattan, an economist with the Federal Reserve Bank of Minneapolis.

She and Nobel Prize-winning economist Edward Prescott have conducted research suggesting that, in theory, the stock market was not overvalued in 2000 because the market value of corporate equity and the market value of productive assets were roughly equal relative to gross domestic product.

Their research also indicates that the market was slightly undervalued at the time of the crash in 1929.

Why stocks subsequently imploded remains a bit of a puzzle.

"No one has yet come up with a good model for why we see very large crashes and recoveries," McGrattan said. "We really don't have an understanding of that."

The Chicago Tribune is a Tribune Publishing newspaper.

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