Asset Price Bubbles: A Survey by Anna Scherbina, Bernd Schlusche :: SSRN

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Asset Price Bubbles: A Survey by Anna Scherbina, Bernd Schlusche :: SSRN

In class next week we will be talking about bubbles. No not this one, nor even this one, but financial bubbles. Financial bubbles have a long history going back decades. A few examples: the famous Dutch Tulip Bubble, the South Sea Bubble (1720)--BTW WATCH THIS short video on it, VERY GOOD!),the late 1920s US stock market , the Japanese bubble of late 1980s, the Internet Bubble of 1998-2000 (here is a video from that time by CNN that is very telling), and of course the most recent real estate bubble.


One of the papers we will be examining is this by Scherbina and Schlusche:

"The persistent failure of present-value models to explain asset price levels led academic research to introduce the concept of bubbles as a tool to model price deviations from present-value relations. The early literature was dominated by models in which all agents were assumed to be rational and yet a bubble could exist. In many of the more recent papers, the perfect rationality assumption was relaxed, allowing the models to shift the focus to explaining how a bubble may be initiated, under which conditions it would burst, and why arbitrage forces may fail to ensure that prices reflect fundamentals at all times. In light of the recent U.S. real estate bubble, the question of why bubbles are so prevalent is once again a matter of concern of academics and policy makers. This paper surveys the recent literature on asset price bubbles, with significant attention given to behavioral models as well as rational models with incentive problems, market frictions, and non-traditional preferences"

I should add, that these are not all agreed upon as bubbles. Some explain the high volatility merely using high levels of volatility and a real option analysis. This definitely is a source of some price run-ups, but I have a hard time convincing myself that it explains a large portion of the price changes.

Related articles

• Mathematically detecting bubbles before they burst (eurekalert.org)
• An Asset-Pricing Model for the Contagion Age: Polson and Scott - Bloomberg (financeprofessorblog.blogspot.com)
• Housing Prices Article by Steve Keen (gillandrealestate.wordpress.com)

A look at historical bubbles

Interesting

Economics focus: In defence of the dismal science | The Economist

Economics focus: In defence of the dismal science | The Economist:

"Over the years exceptions and “anomalies” have been discovered (even tiny departures are interesting if you are managing enough money) but for the purposes of macroeconomic analysis and forecasting these departures are too small to matter. The main lesson we should take away from the EMH for policymaking purposes is the futility of trying to deal with crises and recessions by finding central bankers and regulators who can identify and puncture bubbles. If these people exist, we will not be able to afford them"

SSRN-Options and the Bubble by Robert Battalio, Paul Schultz

Time to rewrite my class notes.....Like many people I have been telling my classes that at least a portion of the reason that Internet stocks were allowed to get so overpriced during the so-called bubble was that short-sale restrictions prevented investors from shorting the shares to drive down prices.

However, in their Options and the Bubble paper Robert Battalio and Paul Schultz show that even if there were short sale restrictions, the option market was efficient enough to allow investors to circumvent the short restrictions.

Unlike Ofek and Richardson (2003), Battalio and Schultz

"find few cases when synthetic and actual share prices diverge enough to appear to create arbitrage profits from short-selling. Indeed, the option and stock prices track each other so closely that we conclude short sale restrictions did not seem to have an important impact on Internet stocks." [emphasis mine]

They do this by showing that

"short sales of synthetic shares, formed by buying puts and writing
calls, are a viable alternative to selling actual shares short. For Internet stocks during the sample period, the expected proceeds from a synthetic short sale averaged about 99.5% of the expected proceeds from the short sale of actual shares. Even the hard-to-borrow stocks in our sample could be easily sold short synthetically, yielding proceeds that were on average only 0.6% less than the proceeds of an actual short-sale...."

Additionally, the option market was not just along for the ride, but a significant amount of information was being discovered via option markets. In the authors' words:

"We find that price discovery did take place in the options market during our
sample period. Moreover, we find that a larger portion of price discovery took place in the options market on days when the stock price declined."

So if we can't blame short sales restrictions, what caused the bubble? The authors conclude that investors simply did not know that the prices were too high:

"it was not obvious to them that Internet stocks were too high. They were trying to value companies in a new industry with unprecedented levels of recent growth. We academics, along with reporters and regulators, have the unfair advantage of hindsight."

Yet another very cool paper!!!

Cite:
Battalio, Robert H. and Schultz, Paul H., "Options and the Bubble" (March 2004). AFA 2005 Philadelphia Meetings; EFA 2004 Maastricht Meetings Paper No. 3081. http://ssrn.com/abstract=558543

BTW Yes I realize this is not the newest paper, but I just found it when doing class notes for the upcoming semester. So I decided that since I had not seen it before, maybe some of you had not either.

HoustonChronicle.com - Dot-com bubble's legacy: unrealistic expectations

The Houston Chronicle has an interesting look back at the Tech bubble. And lest you think it is all just for historic perspective, remember that many of the students now in finance classes were still in high school and had no interest whatsoever in stocks.

HoustonChronicle.com - Dot-com bubble's legacy: unrealistic expectations

Some of the highlights:

"The Nasdaq is still 58.6 percent off its 2000 high as of Wednesday's close, and the technology and biotechnology corporations that helped create the bubble have either matured into value-oriented companies with realistic profit expectations, or have gone under. By the time the Nasdaq is poised for a new run higher, the entire character of the Nasdaq may have changed."

"The impressive gains in 2003 -- a 25.3 percent rise in the Dow and a 50 percent rise in the Nasdaq-- showed that the market could recover. Still, for many investors, stellar returns may have created an unrealistic picture of a stock market that historically has gained 8 percent to 10 percent a year."

"The final tally: the Dow had fallen 37.8 percent from its high, the S&P 500 lost 49.5 percent, and the tech-heavy and startup-friendly Nasdaq tumbled 77.9 percent."

"Billions of dollars simply ... evaporated."

Read the rest of the article at the Houston Chronicle site.

Just as an aside, while the Houston Chronicle's archive is short (only 7 days free), I consistently find it being my first or second read of the day: well written, easy to navigate, and interesting topics. Keep up the good work HC!

Was it a Bubble?

A two-for-one deal! Send your paper to a conference and it is automatically considered for publication in the RFS!

Call For Papers: THE CAUSES AND CONSEQUENCES OF RECENT FINANCIAL MARKET BUBBLES
August 12-13, 2005

ISDEX, an authoritative and widely cited internet stock index, rose from 100 in January 1996 to 1100 in February 2000 – an incredible increase of about 1000% in four years – only to fall down to 600 in May 2000 – an incredible decrease of about 45% in four months. Amongst big rises and falls in the history of stock market prices, this episode ranks amongst the most spectacular. The RFS-IU conference focuses on these recent financial market bubbles. It aims to address the following three questions: a) Was it a bubble? (How do you define bubbles ex-ante? Can you even define bubbles ex-post?) b) What caused it? (Investors? Managers? Financial advisors? Government policies? Media? Academics?) c) Did it matter? (Any real effects?)

The answers to these three research questions touch upon all sub-disciplines of finance – asset pricing, corporate finance, market microstructure, behavioral finance, international finance, law and finance, and real estate finance.

PROGRAM COMMITTEE: Brad Barber, Utpal Bhattacharya, Joshua Coval, John Graham, Craig Holden, Robert Jennings, Steve Kaplan, Alan Kraus, Maureen O’Hara (chair), Thomas Noe, Jay Ritter, David Scharfstein, Matthew Spiegel, Xiaoyun Yu and Jiang Wang.

SUBMISSION: There is no charge for submission. The RFS will consider all the papers accepted for the conference as submissions to the RFS, and will waive the RFS submission fees for these papers. If a sufficient number of conference papers are accepted by the RFS after their usual rigorous refereeing process, the papers will be published in a RFS special issue. Authors who do not wish to have their papers submitted to the RFS if their papers are accepted for the conference should indicate so at the time of conference submission. Authors are invited to submit theoretical or empirical papers. Papers should be written in English and not have already been accepted for publication. Papers will be blindly reviewed by the program committee. The conference organizers will reimburse reasonable travel expenses and will provide meals and lodging for paper presenters, discussants and session chairs.

SUBMISSION DEADLINE: Please send three hard copies of your paper, with a separate title page and abstract, by April 30, 2005 to:

Utpal Bhattacharya or Xiaoyun Yu
The RFS-IU Conference
Kelley School of Business, Indiana University
1309 East Tenth Street
Bloomington, Indiana 47405

Sponsored by The Review of Financial Studies and The Finance Department of the Kelley School of Business, Indiana University, Bloomington, IN.

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!

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
http://gsbwww.uchicago.edu/fac/finance/papers/bubble6.pdf


Moon and Schwartz abstract
http://www.aimrpubs.org/faj/issues/v56n3/full/f0560062a.html