14. Bubbles Flashcards
Are stock valuations connexted to performance of firms?
Stock valuations sometimes seem to be completely disconnected from the forecasted or observed performance of firms.
Eg. The NASDAQ Composite Index which is heavily weighted in technology firms closed at 2.406.00 on March 10, 1999. On March 10, it had more than doubled, followed by a heavy dcline.
Most observers agreed that many tech/internet stocks were overvalued in the early 2000.
What are bubbles?
A bubble is said to exist when high prices seem to be generated more by investors enthusiasm than by economic fundamentals.
A bubble can only really be detected ex post when the bubble bursts and prices adjust downward.
Investors often react hindsight bias: they claim they knew it all along.
Tech/internet bubble is certaintly not the first price bubble ever observed = Tulip Mania.
What was the Tulip Mania?
Tulip first appeared in Western Europe in the 16yh century. Tulip demand increased mainly in Germany and The Netherlands, by 1630 many cities had specialized Tulip markets.
People were willing to pay fortunes for single tulip bulbs. Florins was the Dutch currency and the tulip mania was a speculative bubble.
One popular explanation: the greater fool theory: people bough because they believed that others were even more foolish.
Was the behaviour in the Tulip mania really irrational?
Tulips come in many different variaties and color patterns and many are truly rare.
Is a tulip connoisseur who pays a very high price for a rare tullipo bulb really more irrational compared to an art collextor who pays millions for a painting?
People’s willingsness to pay for tulip bulbs might have been an expression of their rational preferences at that time.
In February 1637 prices collapsed by about 95% –> sudden change in preferences.
What was the Tech/Internet bubble?
Early 2000s, by now there exists a consensus that the level of the US stock market by the early 2000s reflected investor irrationality.
R. Shiller and Alan Greenspan called this: irrational exuberance = “emational state of investors when they decide on their investment is no doubt one of the most important factors causing bull market” experienced in the late 90s.
Strong rise in the share prices in teh late 90s –> irrational?
One way to look at this, price earnings ratio
Price earnigns ratio gives us an idea how much investors are willing to pay per dollar of earnings = do earnigns justify the rise in prices?
The peak of 44.2 in 1999 was unparallelled. How could investors believe they were paying a reasonable price?
New era with impressive future earnings and efficiency gains du to computers.
What is the investor confidence?
Though current earnings did not justify prices, investors thought that because of advances in technology and the internet, future earnings (not reflected in current earnings) would grow at a rapid rate.
What about investor confidence at that time?
Shiller & the Investor Behavior project
What were the bubble experiments?
First experimental study to report bubbles in an experimental asset market was V. Smith et al (1988)
A typical design: Subjects trade an asset over a fixed number of periods. Asset pays a dividend that is determined/paid at the end of the trading period using a commonly known probability distribution.
Assuming risk neutrality one can easily compute the fundamental value of the asset by multiplying the number of trading periods by the expected dividend each period.
Are bubble experiments close to reality?
Experimental market bubbles are of course simple and obviously do not include all the important features of complex real world markets –> we can still learn a lot from them
For example: bubbles and experience: price bubbles seem more moderate and disappear faster when traders are experienced.
Traders with financial knowledge will value assets closer to their economic value.
A small fraction of experienced traders already seems to moderate price bubbles.
What are the experiments with 2 assets?
Lottery asset’s dividend: small probability to win a lot.
Although both have the same expected valu experimental traders are usually willing to pay more for the Lottery asset.
Salient, high payoff.
Suggestive for probability judgement errors –> according to prospect theory people overweight small probabilities.
Alternative explanation = salience theory, excitement of trading (risk loving behaviour)
Other real world behavioural biases = unrealistic optimism.
What are the conclusions on bubble experiments?
Experiments show that regulations of markets important for the size and duration of price bubbles = retrictions on short selling make bubbles stronger.
Only those who are optimistic about an asset drive the price
A pessimistic investor can only sell = but not shrot sell
This means pessimistic traders can only have an influence prices if they own the asset before.
In such a situation = prices do not reflect the view of the whole market.
Fazit: policy makers should be very cautious in restricting short selling as this decreases market efficiency.
