A stock market bubble is a type of
economic bubble taking place in
stock markets when market participants drive
stock
prices above their value in relation to some system of
stock valuation.
Behavioral finance theory attributes stock market bubbles to
cognitive biases that lead to
groupthink and
herd behavior. Bubbles occur not only in real-world markets, with
their inherent uncertainty and noise, but also in highly predictable
experimental markets.[1]
In the laboratory, uncertainty is eliminated and calculating the
expected returns should be a simple mathematical exercise, because
participants are endowed with assets that are defined to have a finite
lifespan and a known probability distribution of dividends. Other
theoretical explanations of stock market bubbles have suggested that
they are rational,[2]
intrinsic,[3]
and contagious.[4]
Examples
Two famous early stock market bubbles were the
Mississippi Scheme in France and the
South Sea bubble in England. Both bubbles came to an abrupt end in
1720, bankrupting thousands of unfortunate investors. Those stories, and
many others, are recounted in
Charles Mackay's 1841 popular account, "Extraordinary
Popular Delusions and the Madness of Crowds".
The two most famous bubbles of the twentieth century, the bubble in
American stocks in the 1920s just before the
Great Depression and the
Dot-com bubble of the late 1990s were based on speculative activity
surrounding the development of new technologies. The 1920s saw the
widespread introduction of an amazing range of technological innovations
including
radio,
automobiles,
aviation and the deployment of
electrical power grids. The 1990s was the decade when Internet and
e-commerce technologies emerged.
Other stock market bubbles of note include the
Encilhamento occurred in Brazil during late 1880s and early 1890s,
the
Nifty Fifty stocks in the early 1970s,
Taiwanese stocks in 1987 and Japanese stocks in the late 1980s.
Stock market bubbles frequently produce hot markets in
Initial Public Offerings, since investment bankers and their clients
see opportunities to float new stock issues at inflated prices. These
hot IPO markets misallocate investment funds to areas dictated by
speculative trends, rather than to enterprises generating longstanding
economic value. Typically when there is an over abundance of IPOs in a
bubble market, a large portion of the IPO companies fail completely,
never achieve what is promised to the investors, or can even be vehicles
for fraud.
Whether rational or irrational
Emotional and cognitive biases (see
behavioral finance) seem to be the causes of bubbles, but often,
when the phenomenon appears, pundits try to find a rationale, so as not
to be against the crowd. Thus, sometimes, people will dismiss concerns
about overpriced markets by citing a
new economy where the old stock valuation rules may no longer apply.
This type of thinking helps to further propagate the bubble whereby
everyone is investing with the intent of finding a
greater fool. Still, some analysts cite the wisdom of crowds and say
that price movements really do reflect
rational expectations of fundamental returns. Large traders become
powerful enough to rock the boat, generate stock market bubbles.[5]
To sort out the competing claims between behavioral finance and
efficient markets theorists, observers need to find bubbles that occur
when a readily-available measure of fundamental value is also
observable. The bubble in closed-end country funds in the late 1980s is
instructive here, as are the bubbles that occur in experimental asset
markets. For closed-end country funds, observers can compare the stock
prices to the net asset value per share (the net value of the fund's
total holdings divided by the number of shares outstanding). For
experimental asset markets, observers can compare the stock prices to
the expected returns from holding the stock (which the experimenter
determines and communicates to the traders).
In both instances, closed-end country funds and experimental markets,
stock prices clearly diverge from fundamental values. Nobel laureate Dr.
Vernon Smith has illustrated the closed-end country fund phenomenon
with a chart showing prices and net asset values of the Spain Fund in
1989 and 1990 in his work on price bubbles. At its peak, the Spain Fund
traded near $35, nearly triple its Net Asset Value of about $12 per
share. At the same time the Spain Fund and other closed-end country
funds were trading at very substantial premiums, the number of
closed-end country funds available exploded thanks to many issuers
creating new country funds and selling the IPOs at high premiums.
It only took a few months for the premiums in closed-end country
funds to fade back to the more typical discounts at which closed-end
funds trade. Those who had bought them at premiums had run out of
"greater fools". For a while, though, the supply of "greater fools" had
been outstanding.
Positive feedback
A rising price on any share will attract the attention of investors.
Not all of those investors are willing or interested in studying the
intrinsics of the share and for such people the rising price itself is
reason enough to invest. In turn, the additional investment will provide
buoyancy to the price, thus completing a
positive feedback loop.
Like all dynamic systems, financial markets operate in an ever
changing equilibrium, which translates into price
volatility. However, a self-adjustment (negative
feedback) takes place normally: when prices rise more people are
encouraged to sell, while fewer are encouraged to buy. This puts a limit
on volatility. However, once positive feedback takes over, the market,
like all systems with positive feedback, enters a state of increasing
disequilibrium. This can be seen in financial bubbles where asset
prices rapidly spike upwards far beyond what could be considered the
rational "economic value", only to fall rapidly afterwards.
Effect of
incentives
Investment managers, such as stock
mutual fund managers, are compensated and retained in part due to
their performance relative to peers. Taking a conservative or contrarian
position as a bubble builds results in performance unfavorable to peers.
This may cause customers to go elsewhere and can affect the investment
manager's own employment or compensation. The typical short-term focus
of U.S. equity markets exacerbates the risk for investment managers that
do not participate during the building phase of a bubble, particularly
one that builds over a longer period of time. In attempting to maximize
returns for clients and maintain their employment, they may rationally
participate in a bubble they believe to be forming, as the risks of not
doing so outweigh the benefits.[6]
See also
References
-
^
Smith, Vernon L.; Suchanek, Gerry
L.; Williams, Arlington W. (1988). "Bubbles, Crashes, and
Endogenous Expectations in Experimental Spot Asset Markets".
Econometrica (The Econometric Society) 56 (5):
1119–1151.
doi:10.2307/1911361.
JSTOR 1911361.
-
^
De Long, J. Bradford; Shleifer,
Andrei; Summers, Lawrence H.; Waldmann, Robert J. (1990). "Noise
Trader Risk in Financial Markets". Journal of Political
Economy 98 (4): 703–738.
doi:10.1086/261703.
-
^
Froot, Kenneth A.; Obstfeld,
Maurice (1991). "Intrinsic Bubbles: The Case of Stock Prices".
American Economic Review (American Economic Association)
81 (5): 1189–1214.
JSTOR 2006913.
-
^
Topol, Richard (1991). "Bubbles
and Volatility of Stock Prices: Effect of Mimetic Contagion".
The Economic Journal (Blackwell Publishing) 101
(407): 786–800.
doi:10.2307/2233855.
JSTOR 2233855.
-
^ Sergey Perminov,
Trendocracy and Stock Market Manipulations (2008,
ISBN 978-1-4357-5244-3).
-
^
Blodget-The Atlantic-Why Wall St. Always Blows It
External links