Bubbles and Busts:

1

• Bubbles and Busts
• From the 1920s to the 1990s

1999!
2
History is continually repudiated. --Glassman
and Hassett The Dow 36,000 (1999)

• What can we learn from history?
• Booms and busts have common elements
• Evidence weak that booms are solely
  fundamentals driven
• Evidence weak that booms are mania-driven
• Role of Federal Reserve is very limited and
  should not be pre-emptive

3
KEY ISSUES

• Boom
• Fundamentals
• Bubble Formation
• Fraud
• Bust
• Precipitating Factors
• Financial Consequences
• Real Consequences
• Policy Lessons
• Monetary Policy
• Financial Supervision

4
Whats a Stock Market Boom?

• Booms are relatively rare long upward swings
  that dominate any brief retreat.
• Annual data is the most appropriate frequency to
  identify a boom.
• An arbitrary criterion that picks out the
  popularly-identified booms three consecutive
  years of returns over 10 percent.

5
Whats a Stock Market Crash?

• October 1929 and October 1987, universally agreed
  to be crashes, are used as benchmarks. In both
  cases, the market fell over 20 percent in one and
  two days time.
• The fall in the market, or the depth, is one
  characteristic of a crash. There was no sudden
  decline for 2000. Speed is another feature.
• Crashes are identified with windows of a day, a
  week, a month and a year to capture other
  declines.

6
Identifying a boom by (about) three years of
annual returns over 10

• 1921-1928 20, 26, 2, 23, 19, 13, 32, and 39.
• 1942-1945 11, 18, 15 and 30.
• 1949-1956 18, 22, 15, 13, 2, 39, 25.
• 1963-1965 17, 13, and 9.
• 1982-1986 22, 14, 4, 19 and 26.
• 1995-1999 27, 21, 22, 25 and 12.

7
Crashes Where the Dow Jones, SP500 or Nasdaq
declined more than 20

• 1903
• 1907
• 1917
• 1920
• 1929
• 1930-1933
• 1937
• 1940

• 1946
• 1962
• 1969-1970
• 1973-1974
• 1987
• 1990
• 2000.

8
Matching booms with crashes

• Booms
• 1924-1929
• 1942-1945
• 1982-1987
• 1995-2000

• Crashes
• 1929/1930-1933
• 1946
• 1987
• 2000

Recovery after 1946 and 1987 was quick, so the
closest parallel to the 1990s is the 1920s
9
Do Booms and Busts Share Common Features?
10
Do Booms and Busts Share Common Features?
11
Do Booms and Busts Share Common Features?
12
Table 1 Characteristics of Booms and Busts
13
What causes stock market booms and abrupt
reversals?

• Probabilities of long positive runs are small
• Probabilities of crashes are small
• Can fundamentals really shift that fast?
• Or is the crowd just mad?

14
Fundamentalists and Maniacs in the 1920s

• Professor John B. Williams of Harvard (1938)
  wrote
• Like a ghost in a haunted house, the notion of
  a soul possessing the market and sending it up or
  down with a shrewdness uncanny and superhuman,
  keeps ever reappearing.Let us define the
  investment value of a stock as the present worth
  of all the dividends to be paid upon it.
• John Maynard Keynes (1936) chose to differ
• A conventional valuation which is established
  as the outcome of the mass psychology of a large
  number of ignorant individuals is liable to
  change violently as the result of a sudden
  fluctuation of opinion which do not really make
  much difference to the prospective yield..the
  market will be subject to waves of optimistic and
  pessimistic sentiment, which are unreasoning.

15
Fundamentalists and Maniacs in the 1990s

• Robert Shiller (1991) observed
• I present here evidence that while some of the
  implications of the efficient markets hypothesis
  are substantiated by data, investor attitudes are
  of great importance in determining the course of
  prices of speculative assets. Prices change in
  substantial measure because the investing public
  en masse capriciously changes its mind.
• John Cochrane (1991) expounded
• We can still argue over what name to attach to
  residual discount-rate movement. Is it variation
  in real investment opportunities not captured by
  current discount model? Or is it fads? I argue
  that residual discount-rate variation is small
  (in a precise sense), and tantalizingly
  suggestive of economic explanation. I argue that
  fads are just a catchy name for the residual.

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Fundamentals

• Fundamentals require that stock prices equal the
  present discounted value of expected future
  dividends.
• The simplest approximation to this fundamentals
  based stock market valuation is the Gordon growth
  model.
• Dividends (D) grow at a constant rate g and
  investors command a constant return of r,
  composed of a risk free rate and an equity
  premium. A constant fraction of earnings are
  paid out as dividends, so that D (1-b)E
• For the aggregate price level of the stock
  market, P, the model is
• (1) P (1g)D/(r-g)
• The Gordon growth model may also be written as
  the price-dividend ratio or the dividend yield
• (2) P/D (1g)/(r-g) or (D/P)(1g) r-g

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• The Gordon model captures all explanations for
  asset price movements, including booms and busts
  
• Technological change increasing productivity and
  leading to higher dividend growth
• Changes in the payout rate
• Changes in the risk free rate
• Changes in the equity premium

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Frustrating!

• Explaining actual stock price movements with
  fundamentals has proved frustratingly difficult.
  
• If expectations are rational, stock prices should
  embody the realized dividends in the future
  appropriately discounted.
• In a classic article, Shiller (1981) found that
  stock prices moved far more than was warranted by
  the movement in dividends, where the ex post
  rational price was equal to the discounted value
  of the future stream of realized dividends.
• Even if there were deviations in was expected
  from what was realized, the fit should have been
  good over 1871-1979, yet the variation of prices
  exceeded the variation in fundamental prices
  violating any reasonable test.

19
Campbell and Shiller (1988)
20
Empirical Regularities

• While it has proved difficult to explain the
  behavior of prices in terms of the movements of
  future dividends, a different literature has
  found empirical regularities
• Empirically the behavior of current prices is
  explained (R210) in terms of past fundamentals.
  
• This predictability is surprising, given that
  prices should be forward looking, but it provides
  an instrument for analyzing stock prices.

21
Lamont (1998)
22
Empirical RegularitiesFama French-Lamont--Campb
ell Shiller etc.

• Changes in the lagged dividend yield (D/P), the
  earnings yield (E/P), and payout ratio (D/E) have
  explanatory power for stock returns.
• Higher D/P predict higher future returns because
  dividends measure the permanent component of
  stock prices.
• Higher E/P or D/E forecasts lower returns because
  the level of earnings is a measure of current
  business conditions, and reflects the transitory
  component

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The 1920s
24
The 1990s
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Two Booms1920s v. 1990s

• Zero inflation, 4 unemployment, balanced budget
• Real Earnings jump
• Real Dividends jump
• Payout Ratio constant
• Soaring Prices
• Collapse in D/P and E/P
• Empirical regularities big fall in D/P forecasts
  lower future returns, mitigated by falling E/P.

• Low inflation, low unemployment, balanced budget
• Real Earnings jump
• Real Dividends dont
• Payout Ratio drops
• Soaring Prices
• Collapse in D/P and E/P
• Empirical regularities big fall in D/P
  forecasts lower future returns, mitigated by
  falling E/P.

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One Forecast

• Lamont (1998) forecasted the cumulative return of
  buying stocks on December 31, 1994---hold five
  years---December 31, 1999
• For sample (1947-1994), the mean excess return
  was 33.
• VAR Forecasting out-of-sample forecast is 1
  below total Treasury bills returns! (potential
  total forecast error of 21)
• His conclusion in the mid-1990s, stock prices
  were very high relative to any benchmark

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Explanation 1 Technological Change or the New
Economy

• In the 1920s and 1990s bull markets,
  technological innovations were viewed as
  improving the marginal product of capital,
  increasing earnings and hence dividend growth.
• A wave of innovations, sometimes characterized as
  a new general purpose technology was believed to
  have placed the economy on a higher growth path.
  

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The New Economy of the 1920s

• Irving Fisher the stock market boom justified
  by the rise in earnings, driven by the systematic
  application of science and invention in industry
  and the acceptance of the new industrial
  management methods.
• High Tech Industries Automobiles, Radio,
  Aircraft, Movies, Electric Utilities, Finance
• But some executives (A.P. Giannini of Bank of
  Italy) feel prices are too high and say they will
  not pay higher dividends.

29
The New Economy of the 1990s

• General purpose technology of 1990s greater
  impact than in 1920s.
• Moores Law number of transistors per
  integrated circuit doubles every 18 months, helps
  drive price declines.
• Estimated average annual price declines for
  electricity and automobiles 2, but computer
  prices collapsed at a rate of 24.
• Faster rate of change and price decline in the
  1990s, promised higher levels of growth and
  consumption.

30
The New Economy of the 1990s

• Gordons (2000) estimates of annual multi-factor
  productivity growth
• 1870-1891 0.39
• 1890-1913 1.14.
• 1913-1928 1.42
• 1928-1950 1.90 Golden Age of GP Tech
• 1950-1964 1.47
• 1964-1972 0.89
• 1972-1979 0.16
• 1979-1988 0.59
• 1988-1996 0.79
• 1995-1999 1.35 IT revolution of a 0.54
  unsustainable cyclical effect and 0.81 trend
  growth which he attributes wholly to the
  computer-IT sector.

31
1920s Fundamentals? Yes?

• Sirkin(1975) applied Gordon model to Dow-Jones
  stocks in the 1920s to see if P/E ratios could
  have been justified by a temporarily higher
  growth of earnings.
• Mean and median at the peak in 1929 were 24 and
  20. In his best case, assuming r9, if the
  higher growth rate of 8.9 typical of 1925-1929
  had been sustained for ten years, the
  price-earnings ratio of 20 would have been
  justified.
• Non-nested calibrations. No other variables.
  Sensitive to time choice. Growth rate for
  1927-1929 justifies or over-justifies all P/E
  ratios.
• Results reflect econometric fact that earnings
  are highly variable, compared with the permanent
  component of dividends and represent the
  transitory component of stock priceslong-term
  projections are hazardous.

32
1920s Fundamentals? Yes?

• Donaldson and Kamstra (1996) estimated a
  non-linear ARMA-ARCH model for discounted
  dividend growth for the 1920s
• Out-of-sample forecasts produce a fundamental
  price series with a similar time pattern to the
  actual SP index.
• Non-nested. No significant variation in the
  equity premium. Fundamentals peak follows the
  actual peak, suggesting that the fit may partly
  reflect the highly persistent behavior of
  dividends.

33
Donaldson Kamstra (1996)
34
1990s Fundamentals?

• The differences in productivity growth in the
  late 1990s between IT industries and the rest of
  the economy look like a potential good
  explanation for the Nasdaqs behavior
• But the boom outside of the new economy would
  seem surprising without a major increase in
  productivity growth.

35
1990s Fundamentals?

• Heaton and Lucas(1999) applied a Gordon model to
  SP500 data. They calculate the growth rates that
  would be needed to justify the peak P/D.
• For (1872-1998), average P/D was 28 and real g
  was 1.4, implying an r of 5.
• To match the 1998 high ratio of 48 with r of 5
  and 7 would require g of 2.9 and 4.9---huge
  historical leaps--a doubling of productivity
  growth

36
Explanation 1?

• For both the 1920s, the conclusion for the 1990s
  is fairly clear expected dividend growth was not
  a major factor driving the boom. The surge in
  earnings was part of a robust business cycle but
  did not have a sufficient permanent component to
  raise stock prices

37
Explanation 3 Changes in the Discount Rate

• The return required or stock yield (r) has become
  the favored factor behind stock market booms.
• R risk free rate and an equity premium. It is
  believed to be moved primarily by the latter, as
  the risk free rate is held to be relatively
  constant.
• In the Gordon model (constant g), the stock yield
  is
• (3) rt E(Dt1 /Pt ) g
• The equity premium is then calculated as the
  difference between the stock yield and a measure
  of the risk free rate.

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39
The Equity Premium

• For 1871-2003
• D/P 4.5
• Real g 1.7
• Real 10 year bond yield 3.2
• Equity premium 3.1
• Trends 19th century 4, surged during Great
  Depression, slow decline, very small now.
• Booms Below 2 1929, near zero 1990s

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Bullish on the Equity Premium

• A Paradigm Shift Glassman and Hassett, The Dow
  36,000 (1999) diversified portfolio of stocks no
  more risky than U.S. government bonds
• Stocks should be priced two to four times
  higher---today. But it is impossible to predict
  how long it will take for the market to recognize
  that Dow 36,000 is perfectly reasonable. It
  could take ten years or ten weeks. Our own guess
  is somewhere between three and five years, which
  means that returns will continue to average about
  25 p.a.
• Rationale premium can fall from 2.8 to 0.8
  real long term bond rate of 2 and g 2.3
  permits a D/P of 1.5 to fall to 0.5 with a
  tripling of P.

41
Why has the equity premium fallen?

• 1920s
• Lower transaction costssecurities affiliates
  improve services, better ticker and wire services
• Increased participationsurge of new middle class
  investors
• Increased diversification by investorsinvestment
  trusts make it easier to diversify

• 1990s
• Lower transaction costsmutual funds, internet
  trading, computerization
• Increased participationmany more households buy
  stocks
• Increased diversificationmutual funds, 401(k)
  make it easier to diversify

42
But..many are skeptical of explanations

• Households switch from individual stocks to
  mutual funds, but no huge shift in shares of
  wealth holding
• New participants do not own much of total stock
• Diversification still low. Many hold
  disproportionate share of own company stock
• Lucas and Heaton (1999) OLG model no effect from
  participation increase, very modest from
  diversification
• Campbell and Vuolteenaho (2004) find evidence of
  mispricingbondholders quickly adjust to
  inflation but not stockholders

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Bottom Line

• Fundamentals dont explain booms well, neither
  rapid productivity growth nor a falling equity
  premium seems to offer a good explanation
• Flood and Hodrick (1990) any test for a bubble
  is troubled by the problem that the dynamics of
  asset prices with a bubble will not appear to
  different from the dynamics when there is an
  omitted factor. Studies which purport to find a
  bubble can be attacked for failing to find some
  missing fundamental, while results where the
  conclusion is that there is no bubble are highly
  sensitive to the choice of parameters (White,
  2006)

44
De Long and Shleifer (JEH 1991)

• To avoid the problem of mis-identifying
  fundamentals, De Long and Shleifer (1991)
  examined the prices of closed-end mutual funds,
  where fundamental value of a fund is simply the
  current market value of the securities in the
  funds portfolio.
• Usually, there is a small discount for closed-end
  mutual funds.

45
Huge growth in these funds irrational
exuberance??
46
Median seasoned fund sold for a premium of 37
percent in the first quarter of 1929, rising to
47 percent in the 3rd then in the 4th.
Instead of buying a fund that was above its
fundamentals price, investors could simply have
been purchased a portfolio of the underlying
stocks or entrepreneurs could have created new
funds with the same stocks. TThe only
consistent explanation is that investors were
excessively optimistic, suggesting the existence
of a bubble.
47
Rappoport and White (1994)

• Evidence in the market for brokers loans that
  lenders were very skeptical of the height that
  the market had attained in late 1929.
• Extraordinary interest premia and margin demanded
  on these loans suggest that lenders felt they
  needed this protection against a potentially huge
  decline in the market.

48
Brokers Loans as Optionsto repay
49
Extracted the volatility implied by the price of
these loans as options, revealing the potential
for a crash on the order of 25 to 50 percent well
in advance of October 1929
50
Costs of a Bubble Distorted Decisions

• Keynes (1936) Speculators may do no harm on a
  steady stream of enterprise. But the position is
  serious when enterprise becomes the bubble on a
  whirlpool of speculation. When the capital
  development of a country becomes a by-product of
  the activities of a casino, the job is likely to
  be ill-done.
• A bubble will (1) raise household wealth causing
  higher than optimal consumption, (2) produce
  overinvestment it will raise market value to book
  value in Tobins q, and (3) induce more firms to
  borrow because of higher value of collateral and
  firms switch to equity finance if there is a
  lower equity premium. Crash will create credit
  crunch.

51
Should the Fed intervene? Whats the optimal
policy

• Powerful traditional lesson---drawn from
  experience of 1928-1933---is keep monetary policy
  focused on inflation and growth, not the stock
  market
• Update In a small calibrated model, Bernanke and
  Gertler (2000) found that an inflation-targeting
  rule stabilizes inflation and output when asset
  prices are volatile, driven by a bubble or
  technology shock.
• No additional gain from responding directly to
  asset prices because a response to stock prices
  lowers the variability of the output gap, but
  increases the variability of inflation. Argue it
  is more difficult to identify the fundamental
  component of stock prices than it is the output
  gap.

52
Exception

• Inflation targeting is flexible. Intervention
  is appropriate for a central bank as lender of
  last resort to intervene temporarily in a
  payments crisis or financial intermediation
  crisis and then withdraw injected liquidity (as
  in 1929 and 1987).

53
Some argument for pre-emptive action

• Cecchetti, Genberg, Lipsky, and Wadhwani (2000)
  Fed should respond to forecasts of future
  inflation, the output gap, and asset prices.
• Argue that it is no more difficult to measure
  stock price misalignments than it is the output
  gap. Find warranted premium in 2000 was 4.3.
• Their model suggests that in 1997, the Federal
  Funds rate should have a Fed funds rate of 10
  not 5.5 to keep inflation less than 3, a very
  small output gap and a risk premium of just under
  3.

54
A Closer LookThe Role of the Fed

• How did policy makers in the twenties and
  nineties confront the booming markets?
• Did their policies hinder or aggravate the booms?
  
• The general economic conditions and the behavior
  of the Federal Reserve in the 1920s and 1990s are
  similar and offer instructive comparisons.
• Three potential lessons

55
Backdrop to the Booms

• 1920s long post-World War I economic boom,
  preceded by high inflation, hard recession and
  many bank failures.
• 1922-1929, GNP grew at 4.7, unemployment
  averaged 3.7. (2 brief recessions), and no
  trend inflation
• Fed accommodated seasonal demands for credit and
  attempted to smooth economic fluctuations.

• 1990s inflation of the 1970s, bank failures of
  1980s, a sharp recession in 1990-1991.
• 1991-2001 longest expansion GNP grew at 3.3 and
  unemployment averaged 5.5,with inflation
  averaging 2.5.
• Fed focuses on interest rate targeting to smooth
  economic fluctuations.

56
Fed blamed for fueling the boom

• Following the Asian crisis, the Fed eases credit
  and cuts the Fed funds rate to reassure market
  after September 1998 collapse of Long-Term Credit
  Management (LTCM).
• Critics asset policy too loose, allowing boom in
  the stock market to take off in its final phase.
• They argue that it was too late when the Fed
  finally began to raise interest rates in June
  1999.

• Expansionary monetary policy begun in the spring
  of 1927 to ease pressure on the British balance
  of payments following secret central bank
  meeting.
• Critics assert policy too easy, and allows boom
  to ignite.
• Fed tightens policy in 1928 and there is little
  increase in total money or credit for 1928-1929.

57
One key difference real bills doctrine

• In the 1920s, most of Fed believed in real bills
  doctrine and saw the boom in the market as
  diverting credit from productive to speculative
  uses. Believed that if banks would restrict
  lending to real bills it would stabilize the
  economy.
• Hence, the Board was obsessed with the stock
  market and the credit used to fund holding stocks
  (brokers loans.)

58
Jawboning, and then..

• In 1996, Alan Greenspan warns that the stock
  market was possessed by irrational exuberance.
• Continued boom, no response, appears Fed believes
  in New Economy
• Fed begins to increase the Fed funds rate in June
  1999.
• Market begins collapse (Peaks Nasdaq 3/2000,
  SP500 8/2000

• In February 1929, Board chairman Young spoke out
  against excessive speculation. Direct pressure
  on member banks to limit "speculative loans. NY
  Fed opposes and wants to raise rates
• Continued boom, credit to market from other
  sources. No further response from stalemated
  Fed.
• August 1929 when the discount rate was raise from
  5 to 6, just as the economy reaches its cyclical
  peak.
• Crash October 2000

59
Lesson 1? Mistaken Monetary Ease

• Complaint Loose Fed policy in 1998 after
  LTCMsome question whether a lender of last
  resort operation was needed.
• August-October 1998 market flat or in retreat.
  Equity premium low but little different than in
  previous years.
• Hard to identify signal for intervention

• Complaint Loose Fed policy in 1927 fed boom.
• But M1 growth modest at 1 and cycle peak in
  October 1926. Indicators and simple Taylor rule
  suggest easier policy.
• No sign of boom in market, June 1927 level with
  June 1925. Equity premium at 4.7 its historic
  level
• No signal for intervention from Bordo Jeanne
  rule of 3 years rapid growth or Cecchettis
  deviation from equity premium.

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Lesson 2? Should the Fed also focus on the stock
market?

• 1928-1932 Fed obsessed with the stock market
• Even in 1930, market still much higher than 1927
  and equity premium still low.
• Continued worry over stock market leads to
  excessively tight policy after stock market crash
  when still worried about speculative excess.

• 1998-2003 Consensus (exception Cecchetti) that
  Fed has not focused on the stock market, but on
  inflation and output gap
• Yet, worry that low rates keep market high

61
Lesson 3 Intervention in a Crash?

• NY Fed injects liquidity into market in response
  to crash of October 1929
• Stressed brokers and customers need credit as
  margin calls are made.
• Danger of collapse of securities firms and
  clearing and settlements system.
• Interest rate spreads widen then close as crisis
  abates. Board criticizes NY Fed, credit tightened
  even though country sliding into depression.

• Fed injects liquidity into market in response to
  crash of October 1987.
• Stressed brokers and customers need credit as
  margin calls are made and specialists and traders
  find it difficult to obtain credit.
• Danger of collapse of securities firms and
  clearing and settlements system.
• Interest rate spreads widen then close as crisis
  abates. and Fed withdraws liquidity

62
Conclusion

• Measures of stock market boom fundamental and
  bubble components are fragile at best.
• Although there may be a bubble in the market,
  central banks should not intervene but focus on
  inflation and growth
• Central banks proper role is as a lender of last
  resort if a stock market crash threatens the
  payment system or intermediation.