Economics environment: Stock market booms (and busts)

Evidence is mounting of a share price boom (or ‘bubble’) in the market for IT shares. Memories are still (fairly) fresh of the “dotcom” boom which turned into a spectacular bust in 2000 and once again, technology hotspots are buzzing with excitement. Want a share in Facebook or Twitter? They don’t have stock market listings (yet) but the markets value them at $76 billion for Facebook (more than Boeing or Ford) and $7.7 billion for Twitter. What’s going on and what does it mean for businesses?

Stock markets can seem baffling, but the concept is very simple. Giant enterprises are too big for even a very wealthy person to finance. Joint stock companies were invented to get round the problem. Individuals can provide a share of the finance and take just a share in the risk. As a reward they get a share of the profits. Shares in public limited companies are openly sold on stock markets, where their value is determined by supply and demand. Popularity pushes up prices.

LinkedIn, a social network for professionals has just launched with shares priced at $45 (£27.73). A mad scramble amongst investors soon pushed their price up to $122 at one point and ended the first day of trading at $94.25. The company is now valued at more than $10,000m even though last year they only made a profit of $15.4m on revenues of $243m (see The Guardian). I love a quote later in the article: one New York stockbroker who did not buy LinkedIn shares said: “If I had, I would be out in the bar celebrating. The price is the price. If people think that this is what it’s worth, this is what it’s worth.”

Evidently, Microsoft think Skype is worth $8.5 billion—ten times its sales revenue last year and 400 times its operating income, because that’s what they paid. A mad stampede is gathering force. Does this mean that a crash will follow? Back in 2000, few people were plugged into the internet; today there are 2 billion netizens, many of them in huge new wired markets such as China. A dozen years ago ultra-fast broadband connections were rare; today they are common. And some have phenomenal sales and already make respectable profits. Facebook may turn out to be the next Google, and so on.

But a bust looks entirely possible, and the last one in 2000 did massive damage. When internet firms’ share prices plummeted, telecoms investors suffered too. The exploding of the property bubble was disastrous. If everyone runs for the exit at the same time, fortunes evaporate, confidence dives, firms struggle to raise finance and the weak economic recovery in Britain could be hit hard. The graph below shows an index of share prices – the FTSE – and you can clearly spot market wobbles in 2000 and 2007. What’s coming in 2012?

Data from Timetric.

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FTSE all shares, price index, at the end of the month, monthly from Timetric