Lecture 23: Stock Market Booms and Crashes

Brief History of Booms and Crashes

• For hundreds of years, speculative markets have undergone dramatic ups and downs, that appear irrational to many observers

• Tulipmania, 1630s, Holland• Mississippi Scheme, 1720, France, John Law’s

Mississippi Company had monopoly of trading for province of Louisiana.

• South Sea Bubble 1720, England, South Sea Company had British monopoly on trade in South Seas

Up-Crashes

• Popular view that markets rise slowly and crash suddenly is overblown

• January 3, 2001, Nasdaq went up 14% in one day, following rate cut

• October 6, 1931, Dow went up 14.87% following President Hoover’s plan for economic recovery

• Biggest 1-day crash October 19, 1987 Dow fell 22.6%, much larger than largest upcrash, but also twice as big as next largest downcrash

Mackay vs. Garber

• David Mackay, Extraordinary Popular Delusions and the Madness of Crowds, 1841, popularized these stories of bubbles

• Peter Garber, Famous First Bubbles, 2000, said Mackay’s bubble stories were not inconsistent with perfect investor rationality

Efficient Markets Hypothesis

• Stock market level is always unforecastable, not inconsistent with crashes

• Volatility may be forecastable, and in that sense crashes may be forecastable

• Efficient markets hypothesis denies the Mackay theory that something fundamentally irrational is going on in booms and crashes

• Fundamental disagreement in the finance profession about how to model markets

Irrational Exuberance

• The Stock Market in Historical Perspective

• Part 1: Structural Factors

• Part 2: Cultural Factors

• Part 3: Psychological Factors

• Part 4: Attempts to Rationalize Exuberance

• Part 5: Tension between Efficient Markets Theory and Financial Innovation

• The Next Few Decades

The Stock Market in Historical Perspective

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Price Earnings Ratio Predicting Subsequent Ten-Year Real ReturnsAnnual January Data, 1881-1990 (1891-2000 returns)

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Faith in the Stock Market

“The stock market is the best investment for long-term holders, who can just buy and hold through the ups and downs of the market.”

1996 1999 2000 2001-2 2002 20031. Strongly agree 69% 76% 63% 60% 46% 39%2. Agree somewhat 25% 20% 34% 31% 40% 44%3. Neutral 2% 2% 2% 3% 5% 8%4. Disagree somewhat 2% 1% 1% 5% 8% 5%5. Strongly disagree 1% 1% 0% 1% 2% 5%

(Individual investors)

Historical Intervals between Normal Years

(Excluding War, Recession)• 1. 1871-1891• 2. 1891-1913• 3. 1913-1928• 4. 1928-1950• 5. 1950-1964

• 6. 1964-1972• 7. 1972-1979• 8. 1979-1988• 9. 1988-1996

Earnings, Productivity & Value

Growth over Historical Intervals

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Part 1: Structural Factors

• Precipitating Factors: the Internet, the Baby Boom, and other events

• Amplification Mechanisms: Naturally Occurring Ponzi Schemes

Precipitating Factors

• The World Wide Web• Triumphalism• Culture Favoring

Business Success• Republican Congress

& Capital Gains Taxes• Baby Boom• Media Expansion

• Optimistic Analysts• 401(k) Plans• Rise of Mutual Funds• Decline of Inflation• Expanding Volume of

Trade• Rise of Gambling

Opportunities

Variations in Factors Since March 2000

• WWW: Dot-com bust weakened faith. Productivity numbers for 1990s revised down, strong productivity growth since then

• Triumphalism: China 9% growth in 2003• Republican Congress: Republican James Jeffords defection to

Independent May 2001, Democratic Senate 51-49, back to Republican senate 51-48 Nov. 2002

• Optimistic Analysts: All major Wall Street firms have announced new guidelines, HSBC abolishes “hold” recommendation, “equal” buy and sell. Post-Enron reforms may reduce incentives for optimistic bias.

• Mutual funds: net new flow into stock mutual funds was $32 billion in 2001, compared to $309 billion in 2000, then back up to $69 billion in year ending February 2004 (all in first two months of 2004).

Amplification Mechanisms

• Price-to-price

• Price-to-gdp-to-price

• Price-to-earnings-to-price

• Naturally Occurring Ponzi Scheme

Amplification Through Expectations

• PaineWebber/Gallup Poll: Expect 15.0% return on stock market over next 12 months in 1999.

• My polls of individual investors: Expect 4.6% increase in Dow over next twelve months in 1999.

Part 2: Cultural Factors

• The News Media

• New Era Economic Thinking

• New Eras and Bubbles around the World

Largest Recent One-Year Real Stock Price Changes

• Philippines 683.4% Dec. 1985-Dec. 1986• Taiwan 400.1% Oct. 1986-Oct. 1987• Venezuela 384.6% Jan. 1990-Jan.1991• Peru 360.9% Aug. 1992-Aug. 1993• Colombia 271.3% Jan 1991-Jan. 1992• Jamaica 224.5% Apr. 1992-Apr. 1993• Chile 199.8% Jan. 1979-Jan. 1980• Italy 166.4% May 1985-May 1986

Part 3: Psychological Factors

• Psychological Anchors for the Market

• Herd Behavior and Epidemics

Prominent Psychological Theories

• Anchors: Kahneman & Tversky Wheel of Fortune experiment

• Overconfidence

• Attention Anomalies

Part 4: Attempts to Rationalize Exuberance

• Efficient Markets, Random Walks, and Bubbles

• Investors’ Learning — and Unlearning

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Irving Fisher 1929

“It was only as the public came to realize, largely through the writing of Edgar Lawrence Smith, that stocks were to be preferred to bonds during a period of dollar depreciation, that the bull market began in good earnest to cause a proper valuation of common shares.”

The Crash of 1929

• Complete absence of news

• Smoot-Hawley Tariff not news

• Sequence of events led to bottom 1932

The Crash of 1987

• Lawrence Harris, “The October 1987 S&P Stock Futures Basis

• Futures price too low to be explained by nontrading lags in index

Questionnaire Survey Oct 1987

• Average time individuals heard of the crash, 1:56pm EDT (10:56am PDT) October 19, 1987

• Average individual spoke to 7.4 other individuals about stock market that day

• 81.6% of individuals heard about the crash before 5pm

Ranking of Importance of News Stories

1. The 200-point drop of the Dow that morning 5.14 (on 1-7 scale)

2. Drop in Dow October 14-16 4.54

3. Treasury bond yields hit 10.5% 4.27

4. Trade deficit figures 4.21

5. Chemical bank raises prime rate 4.14

6. Baker suggesting dollar should fall 4.04

Psychology or Fundamentals?

• Which of the following better describes your theory about the declines: a theory about investor psychology or a theory about fundamentals such as profits or dividends– Psychology 67.5% individuals, 64.0%

institutional

1987: Investors Thought They Knew What Will Happen

• “Did you think at any point on October 19, 1987 that you had a pretty good idea when a rebound was to occur?”-Individuals 29.2% yes, Institutions 28.0% yes

If Yes, why?-gut feeling, intuition, market psychology, common sense, story telling

The Nikkei Crash after 1989

• Nikkei peaked last day of 1989, nearly 40,000• Has remained below half that since• High expectations for Japanese economy in 1980s• Bubble Economics, Yukio Noguchi 1992• Many reasons for slow growth in Japanese

economy since then, but tend to be related to bubble situation in 1980s

• Nikkei 1989 a model for Dow 2000?

Samuelson’s Dictum

• Market Efficiency Theory Has Some Merit

• Samuelson’s Dictum: Some evidence of micro efficiency and macro inefficiency

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Part 5: Tension Between Efficient Markets Theory and Behavioral

Finance• Aggregate markets are not very efficient

• Investors make many systematic mistakes

• And yet, financial markets matter very much for economic success

• All successful economies have sophisticated financial institutions

Concluding Thoughts

The Next Few Decades

• The most exciting prospect: the developing world catches up

• Financial Markets will be everywhere, dominating people’s lives

• Financial booms and crashes will be even bigger than before

• Worse things have happened in history!

Dramatic Change in Finance, our Economy

• Experience of last century suggests dramatic changes in the next

• Information technology unleashes a cascade of other changes in the economy

• Other technology transforms the world economy, creating opportunities and challenges

Risk and Chance over Careers

• Century-long personal outlook

• Reflections on upheavals in last century

• Stock market risk is compounded by individual career risk

• Illusion of invulnerability

Ecclesiastes IX 11

“I returned and saw under the sun that the race is not to the swift, nor the battle to the strong, neither yet bread to the wise, nor yet riches to men of understanding, nor yet favour to men of skill; but time and chance happeneth to them all.”

Career Risks

• Joshua Angrist, Analysis of draft lottery, 1969. Low RSN lowered income decade later by 15%

• Over half of the cross-individual variance in incomes cannot be explained either by age, schooling, experience, parents income, parents occupation, or transitory component [Bowles et al. JEL Dec. 2001]

A Risky World

• Media focus on success

• Longer-run perspective: people in positions come and go by chance

• Careers and economic success “come together” by the strangest coincidences

Human Capital, Positioning, and Meaning

• Maintain an orientation towards history in the making, rather than to one’s own point in the life cycle

• Maintain human capital, strategically oriented

• Maintain humanity in an unforgiving business world

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