The technology-laden Nasdaq Composite stock index experienced a 54% decline from its peak in March 2000 to its low in December 2000. Internet-focused stock indexes such as the street.com (TSC) Internet Sector Index declined 79% over the same period. In com­parison, the Dow Jones Industrial Average actually increased 4%. To put this in perspective, if you had invested $100 in the TSC Internet Sector Index and then lost 79%, you would have $21 left. To get back to $100, you would need to earn a 476% return!

After a market crash, U.S. investors always look to the October 1987 crash for guidance. After a two-day drop of 26%, the stock market recovered in about 15 months. However, the 1987 crash is not the only comparison. Japan ended a decade-long bull market at the end of 1989. The Nikkei Index reached 38,916 before an 18-month-long bear market, which deflated the index to 14,309, a 63% decline. The Nikkei has traded above 20,000 only a few times since 1992 and closed the year 2000 at less than 14,000. It may be a long time before the Internet sector recovers.

The More Things Change...

... the more people stay the same! Market bubbles are not recent phe­nomena. Nor are they uncommon.

One of the most impressive market bubbles occurred in Holland in the 1630s.4 What makes this bubble so amusing is that the com­modity that was so highly sought after was the tulip bulb. Over a five-year period, tulip bulb mania inflated bulb prices to the point where one bulb was worth 10 times a yoke of oxen. A tulip bulb costing nearly $100,000? An out-of-town sailor inadvertently popped the tulip bulb price bubble. Mistaking a bulb for an onion, he ate it. Wondering whether the bulbs were worth the high prices, people erupted into a panic and within a week the bulbs were almost worthless.

Modern market bubbles have common elements. Given the statement below, how would you fill in the blank?

We are in a new era has ush ered in a new type of economy. Those stuck in the old ways will quickly fall away. Traditional company valuation techniques do not capture the value of this revolution.

Given the nature of this chapter, you probably said The Internet. However, if you lived in 1850, The railroad would have been the best answer. If you lived in the 1920s, you might have said The Federal Reserve System ushered in a new economy. In the mid-1950s, the answer would have been The New Deal. Even as recently as 1990, you might have said biotechnology created a new type of economy. In each case, the people became irrationally exuberant over the idea that a new technology or government would make the old economy obsolete. The exuberance fuels a great bull market which precedes a great decline.

Price bubbles are not uncommon, nor is each one unique. The specific details may change, but the basic principles are always the same.

There are certain factors that contribute to the mania that causes market bubbles:

■    Short-term focus. During a market bubble, your mind-set is more like that of a trader than an investor. Instead of buying a stock because you think the company's products, market share, and management will be dominant in the future, you buy a stock because you think the price will rise in the next week, day, or hour. The firm's products, market share, and management become ancillary, or even irrelevant. Take Sharon, for example. She was interviewed by the PBS show Frontline.5 She invested her family's entire life savings into two tiny technology stocks, most of it in one company. "To tell you the truth, I don't even know the name of it. I know the call letters are AMLN; it's supposed to double by August," she says. For the record, AMLN is Amylin Pharmaceuticals. During the several months before the airing of Frontline, Amylin traded at around $ 12 a share. By August it was trading at under $8 a share and it closed the year at $5.43 a share. Needless to say, Sharon wasn't too pleased.

■    Faith. "Things are different this time." "The old valuation measures are no longer appropriate." These common comments occur during the formation of a market bubble because the high prices cannot be justified with traditional measures. When the scale says you have gained 30 pounds, the problem is obvious—your scale no longer works. During a market bubble, you invest on the basis of faith, not due diligence.

■    Social validation. You want to talk about it. Investing talk has become popular at social occasions. I have already discussed the online discussion groups. But also consider the expansion of talk radio investment shows and the call-in questions to CNBC. During a market bubble, investing becomes social.

Stock market bubbles do not occur because of new economics or new technologies; they occur because of people's psychology. New bubble. When your overconfi-dence (in Chapters 2 and 3) combines with your emotions (Part 2), you have a problem. When everyone is caught up in his or her own psychology, the problem is magnified.