Lecture 23: Stock Market Booms and Crashes

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Lecture 23 Stock Market Booms and Crashes
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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 Laws
  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

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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 Hoovers 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

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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
  Mackays bubble stories were not inconsistent
  with perfect investor rationality

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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

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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

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The Stock Market in Historical Perspective
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SP500 Jan 1871-Feb 2004
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SP 500 Price/(10-Year Earnings)Jan 1881-Feb 2004
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Nikkei Index, Jan 1984-Feb 2004
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Germany Dax Nov. 1990 Nov. 2003
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UK FTSE 100 April 1984-Nov. 2003
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France CAC 40March 1990- Nov. 2003
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P/E Predicts 10-Year Returns
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One-Year Confidence, USA
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Valuation Confidence, USA
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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 2003
• 1. 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)

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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

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Earnings, Productivity Value
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Part 1 Structural Factors

• Precipitating Factors the Internet, the Baby
  Boom, and other events
• Amplification Mechanisms Naturally Occurring
  Ponzi Schemes

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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

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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).

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Amplification Mechanisms

• Price-to-price
• Price-to-gdp-to-price
• Price-to-earnings-to-price
• Naturally Occurring Ponzi Scheme

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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.

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Part 2 Cultural Factors

• The News Media
• New Era Economic Thinking
• New Eras and Bubbles around the World

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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

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Part 3 Psychological Factors

• Psychological Anchors for the Market
• Herd Behavior and Epidemics

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Prominent Psychological Theories

• Anchors Kahneman Tversky Wheel of Fortune
  experiment
• Overconfidence
• Attention Anomalies

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Part 4 Attempts to Rationalize Exuberance

• Efficient Markets, Random Walks, and Bubbles
• Investors Learning and Unlearning

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Price and Dividend Present Value
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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.

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The Crash of 1929

• Complete absence of news
• Smoot-Hawley Tariff not news
• Sequence of events led to bottom 1932

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The Crash of 1987

• Lawrence Harris, The October 1987 SP Stock
  Futures Basis
• Futures price too low to be explained by
  nontrading lags in index

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Questionnaire Survey Oct 1987

• Average time individuals heard of the crash,
  156pm EDT (1056am 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

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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

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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

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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

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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?

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Samuelsons Dictum

• Market Efficiency Theory Has Some Merit
• Samuelsons Dictum Some evidence of micro
  efficiency and macro inefficiency

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Present Value of Dividend Changes Plotted Against
D/P Ratio
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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

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Concluding Thoughts
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The Next Few Decades

• The most exciting prospect the developing world
  catches up
• Financial Markets will be everywhere, dominating
  peoples lives
• Financial booms and crashes will be even bigger
  than before
• Worse things have happened in history!

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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

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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

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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.

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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

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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

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Human Capital, Positioning, and Meaning

• Maintain an orientation towards history in the
  making, rather than to ones own point in the
  life cycle
• Maintain human capital, strategically oriented
• Maintain humanity in an unforgiving business
  world

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