Tech Bubble: What it is, How it Works, Examples

Tech bubble refers to a pronounced and unsustainable market rise attributed to increased speculation in technology stocks. Rapid share price growth and high valuations based on standard metrics, such as price/earnings ratio or price/sales, normally characterize a tech bubble.

Understanding Tech Bubbles

As a general rule of thumb, bubbles form when excess capital, usually at the latter stages of a credit cycle, is desperate in its search for alpha in saturated markets. While value will be created, the vast majority of the initial public offerings (IPO) will fail. The tech bubble is often cited as a prime example when depicting the characteristics of bubble behavior.

Technology stocks involved in a bubble may be confined to a particular industry (such as internet software or fuel cells), or cover the entire technology sector as a whole, depending on the strength and depth of investor demand. At the peak of a bubble, many fledgling tech companies seek to go public through IPOs in an attempt to capitalize on heightened investor demand.

During the formation of a tech bubble, investors begin to collectively think that there's a tremendous opportunity to be had, or that it's a unique time in the markets. This leads them to purchase stocks at overinflated prices. New metrics are often used to justify these stock prices, while fundamentals, as a whole, tend to take a backseat to rosy forecasts and blind speculation.

Most bubbles end with a crash once investors awaken to the implausibility of the heightened expectations being met, and rush to the exits. Some bubbles might simply deflate as investors slowly lose interest and sales pressure pushes stock valuations back to normalized levels. The dotcom tech bubble, like most bubbles, ended with a crash once investors awoke to the reality that heightened expectations would not be met and rushed to exit en masse.

The Dotcom Tech Bubble

The dotcom tech bubble occurred in the late 1990s and ended abruptly in early 2000. The causes for its downfall are numerous, but evidence of this decline first appeared within the big telecom hardware providers, who at the time were supplying most of the tech startups and dotcoms with servers and networking hardware. Once revenue at the telecoms reduced dramatically, it rippled through their respective end markets and, eventually, the entire economy slipped into recession in 2001.

The Bitcoin Tech Bubble

The rise of Bitcoin from just over $10 in 2013 to $20,000 in late 2017 has been one of the largest tech bubbles of all time. The cryptocurrency surged roughly 2,000% in 2017 before surrendering half of those gains in early 2018. The technology behind Bitcoin, called blockchain, is fueling tech startups to raise money through initial coin offerings (ICOs) to fund their projects. Investors receive tokens or coins in return that can be used on a startup’s platform or traded for speculative purposes on decentralized exchanges. In late 2017 and early 2018, many speculative cryptocurrencies were listing at a significant premium to their ICO price, similar to up-and-coming internet stocks at the height of the dotcom tech bubble.