Thursday, November 11, 2004

Michael Brennan on the Stock Market Bubble

Michael Brennan provides an interesting (and cutting) analysis of how the stock market climbed so high in the late 1990s. He writes that there was plenty of blame to go around and that even FinanceProfessors should take their share of the blame.

He begins by documenting the major bull market from 1980 to 2000:
"Between January 1980 and August 2000 American stock prices as measured by the S&P500 index rose by 1239%; over the same period the dividends on the shares underlying the index rose by only 188%, while the earnings rose by 254%."

The two main reasons that he cites for this run-up were the
"democratization of investment" and the change in conventional wisdom.
1. The "democratization of investment and change in conventional wisdom

These changes "led to an environment where "individuals with little or no experience of the stock market began to invest for the first time."

He attributes this rise in participation to changes in retirement plans (the "demise of the defined benefit plan" and to the "cult of equity."

This so-called cult was allowed to develop in part because "there was ...a general lack of objective discussion in the public marketplace of ideas about the elevated level of stock prices."

This lack of discussion he attributes to poor press coverage and financeprofessors who refused to speak out against the overvaluation.

Moreover, he claims that market efficiency theories from academia led many to be reluctant to publicly speak out against the price rise for the same professor often taught "the Price is right".

Additionally, published articles that showed that equities had out performed all other investments had become well-known by this time. These works were often cited as a means for being invested heavily in stocks even when their prices soared.

2. Agency Problems in the production and sale of information

Not only were investors and professionals over-confident, but there were also conflicts of interest keeping share prices high and investors in the dark as to the true health of companies. In Brennan's words:

"During the 1990's severe problems arose in the production of information at the firm level. This was exacerbated by deficiencies in accounting conventions, and by conflicts of interest faced by accountants and investment analysts. The result was that the underlying profitability of the corporate sector became overstated, causing investors to over-estimate, not just the current level of profits, but also their underlying rate of growth. In this circumstance, it is not surprising that stock prices rose above sustainable levels."
While showing some survey data as evidence that institutional investors were not tricked (that is they felt the stock market was over-valued), the author points out that equity allocations rose in spite of this belief that the stock market was too high. Why? In part because of an agency cost problem:

"...investment managers, whose greatest risk is the business risk of losing their clients, cannot afford to take bets based on long run outcomes, and consequently have incentives to ignore signs of overvaluation: it is better for them to lose their clients' money along with the crowd as the market goes down than to risk saving significantly worse returns than their competitors."
In other words, if the investment manger were wrong in the short run while everyone else is betting the stocks will still rise, (s)he might be replaced. On the other hand, if the fund manager were wrong when everyone else was also wrong, it is less likely to result in a firing.

While most of the article stresses that stock prices should not have risen as much as they did, there was at least one economically justifiable reasons for stock prices rising: a declining risk premium. In his words: "There is evidence that the risk premia in capital markets that might have been assessed by sophisticated investors were declining through the 1990's."

The article ends with a look into the future and a discussion of whether a bubble could happen again. He suggests that the regulatory changes to lessen conflicts of interest and increase transparency are steps in the right direction but that investors and journalists must learn more about finance and not to blindly invest with no expectation of a loss. He also calls on FinanceProfessors to be more vocal:
"Perhaps more important for the aggregate level of prices is a broader understanding among the public of the sources of value for stocks in general.....Greater sophistication on the part of financial journalists would assist in this process, as would the increased involvement of financial economists in the popular media."

A quick, informative, and interesting piece! It brings up many interesting ideas.

BTW in a stroke of uncanny timing, I will be taking part of Brennan's prescription this week. On Saturday I will be on The Kim Snider show on KRLD-AM News radio 1080 out of Dallas Texas. If you are in the area, listen in!


Anonymous said...

Why would a declining risk premium lead to inflated stock prices? Is it because there are more investors 'competing' for the higher returning equities?

FinanceProfessor said...

Consider any pricing model, I will use the (Gordon) Constant growth model for the example:

Price = D(1)/(r-g)

where d(1) is the dividend in year one
r = required return
g = growth rate of dividends

A declining risk premium means that the r gets smaller. So if we allow the dividends and g to remain constant (in fact it can be argued that they may go up, but I digress), then the price of the stock will also go up.

Anonymous said...

I believe the bubble was fed by investors lacking knowledge of past market events. The stock market collapse, 1973-74, or the crash of 1987, certainly reminded me not to overreach. Another lesson that one gains from being in the market for a long period of time is: don't expect to get rich quick. Chasing hot stocks is speculating -- not investing. Those burned in the last bubble -- I expect -- have learned a lesson. Likely we'll not see another bubble until a new generation, blind to the past, finds a "sure way" to easy riches. Human nature rarely changes.