Monthly Archives: May 2016

Back Up; What Was the Dot Com Bubble?

As the today’s tech bubble, comprised of over-valued giants like Uber, AirBnb, and even Apple, prepares to burst (or bursts, as many are coming to say), many look to the dot com bubble as a reference point. But what was the dot com bubble, and how and why did it pop? Here’s a quick overview for those of you that are curious.

dot com bubThe “Dot Com Bubble” is said to have started in April of 1997 and spanned through June of 2003, before it popped. In order to explain how and why all of it happened, it’s first important to establish ¬†working definition of what exactly an economic bubble even is. Let’s use the definition provided by business insider:

“An economic bubble exists whenever the price of an asset that may be freely exchanged in a well-established market first soars then plummets over a sustained period of time at rates that are decoupled from the rate of growth of the income that might reasonably be expected to be realized from owning or holding the asset.”

In other words, an economic bubble occurs when the value of something, be it a service or a company itself, becomes unrooted from what it can be consistently expected to be worth and instead its value enters a volatile and inconsistent state. According to a paper released by Zhonglan Dai, Douglas A. Shackelford, and Harold h. Zhang, this is how the Dot Com Bubble started to inflate:

rise and fall“We use the Taxpayer Relief Act of 1997 as our event to empirically test the impact of a change in the capital gains tax rate on stock return volatility. TRA97 lowered the maximum tax rate on capital gains for individual investors from 28 percent to 20 percent for assets held more than 18 months. TRA97 is particularly attractive for an event study because the capital gains tax cut was large and relatively unexpected, and the bill included few other changes that might confound our analysis. Little information was released about TRA97, until Wednesday, April 30, 1997, when the Congressional Budget Office (CBO) surprisingly announced that the estimate of the 1997 deficit had been reduced by $45 billion. Two days later, on May 2, the President and Congressional leaders announced an agreement to balance the budget by 2002 and, among other things, reduce the capital gains tax rate. These announcements greatly increased the probability of a capital gains tax cut. On Wednesday, May 7, 1997, Senate Finance Chairman William Roth and House Ways and Means Chairman William Archer jointly announced that the effective date on any reduction in the capital gains tax rate would be May 7, 1997. As promised, the lower rate on long-term capital gains (eventually set at 20 percent) became retroactively effective to May 7, 1997, when the president signed the legislation on August 5, 1997.”

The researchers then came across a stunning finding through testing stock market return data before and after May 7, 1997 (the date when investors would understand that a reduction in the capital gains tax would become effective):

“To provide more compelling evidence that the 1997 tax cut affected volatility (and mitigate concerns about omitted correlated variables), we focus on cross-sectional tests which are designed to detect the differential responses in return volatility of stocks with different characteristics. We hypothesize that the effect of a capital gains tax change on stock return volatility should vary depending upon dividend policy and the size of the unrealized capital losses (or gains). Consistent with expectations, we find that non- and lower dividend-paying stocks experienced a larger increase in return volatility than high dividend-paying stocks. We also find that stocks with large unrealized capital losses had a larger increase in return volatility after a capital gains tax rate reduction than stocks with small unrealized capital losses. However, we do not find a similar relation with unrealized capital gains.”

TRA 1997 ended up leaving dividend tax rates at the same rate as regular income in the United States, creating incentive for investors to favor low-to-no dividend paying stocks over those that paid out more significant dividends.

This came to a close when the Jobs and Growth Tax Relief Reconciliation Act of 2003 rolled around, which set both tax rates for capital gains and for dividends at equal rates once again, which they had been from 1986 to 1997. That act ended market volatility and effectively ended the Dot Com Bubble.