Monday, July 12, 2004
Blowing way bubbles?--Maybe the NASDAQ Bubble wasn't a bubble
So maybe there wasn't an internet bubble. Several academic papers are trying to justify the high valuations that existed in the late 1990s.
For instance Pastor and Veronesi (P&V) examine the question and allow for uncertainty in future earnings and, unlike similar work by others, they conclude that the NASDAQ was not necessarily overvalued.
Possible the best way to understand their work is in the spirit of real option analysis where the more uncertain the future, the greater the value of the option (or in this case stock). This is important because "The NASDAQ stock prices in the late 1990s were not only high but also highly volatile, and both facts are consistent with high uncertainty about average profitability." Using a model valuation model that incorporates this uncertainty the authors conclude that "Nasdaq prices at the peak of the 'bubble' are justifable."
(just a note: This is similar to Moon and Swarttz (2000) but P&V find that the uncertainty need not be as large as Moon and Schwartz stated.)
It is important to recognize that this is not to say the market was perfectly rational at the time. As L&V state: "We don't claim that investor behavior in the late 1990s was fully rational....Good examples
of apparent irrationality are presented by Cooper, Dimitrov, and Rau (2001), Lamont and Thaler (2003), and others. Also, we don't attempt to rule out any behavioral explanations for the 'bubble.' We only argue that such explanations are not necessary, because stock prices in March 2000 are also consistent with a rational model. The notion of a Nasdaq "bubble" caused by investor irrationality should not be held as a self-evident truth."
Pastor and Veronesi
Moon and Schwartz abstract