A rising tide lifts all boats.
Most investors are familiar with this bull market refrain. But now that the bubble has burst, now that the economy is certain to have contracted in the third quarter and almost certain to shrink in the fourth quarter, bringing recession, it's important to understand the extent to which a bull market can drive false demand through the economy.
The Internet boom opened the floodgates as venture capital firms poured billions into new economy dreams. VC firms funded 1,879 deals worth $9.8 billion in 1996, according to the PricewaterhouseCoopers MoneyTree survey. By 2000, VC investment had soared almost 800% to $87.5 billion for 5,267 deals.
This isn't a bad thing in itself. One of the U.S. economy's greatest assets is its large pool of entrepreneurial investors. What other way would untested companies obtain access to capital? But the average investor should understand the extent to which easy access to capital makes everyone look like a winner. In the first quarter of 2000 alone, VC firms invested an astonishing $26 billion, more than twice as much as they invested in all of 1996. This much capital creates waves that roll through the entire economy.
Of the $87.5 billion poured into companies by venture capitalists in 2000, 83% of the investments found their way to Internet-related companies, up from 79% in 1999, according to the survey. Early on, the most visible benefactors of this sudden wealth were the dot-com companies. Much that was good -- Amazon.com (Nasdaq: AMZN) -- was funded along with much that was bad -- Pets.com.
The explosion of dot-com companies helped create the surge in demand for infrastructure companies, from Cisco's (Nasdaq: CSCO) hubs and routers, to JDS Uniphase's (Nasdaq: JDSU) optical components, to Sun Microsystem's (Nasdaq: SUNW) high-end servers. The issue isn't that these companies offer unwanted products, but that demand levels of the last year or two were unsustainable. That's why you need more than one year of results to get a feel for a company's earnings power. If you anchor expectations at a highwater mark, you're going to be disappointed.
Even in the old economy, new economy money distorted the facts. The cyclical airline industry always earns higher profits when the economy is booming. Since 1997, airline profits have more than tripled, reaching a record of $18.2 billion last year, according to the Air Transport Association.
Profits soared as demand for air travel expanded faster than airlines could add capacity, which drove up seat prices, according to an article by Shawn Tully in this month's Fortune magazine. Both consumers and business travelers flew more often, but airlines make much more money off business travelers, who often pay larger fares for flights booked at the last minute. Now, businesses are cutting back travel and it's hard to predict when demand will return to 2000 levels. When will the economy create the next tidal wave of business travelers?
Lots of investors got fooled by the bull market. Many lost money in a dot-com company, or an optical components vendor, just as many lost money on electronics stocks in the 1960s, on airline companies in the 1920s and 1930s, and on railroad and canal companies in the 19th century.
Hopefully, we learned something.
Richard McCaffery doesn't own shares in any company mentioned in this report. The Motley Fool is investors writing for investors.