(A thing is worth only what someone else will pay for it.)
The stock market is generally considered to be a rational and efficient animal. However throughout history, episodes of mass hysteria have occurred periodically, when shares or products have been massively overvalued by the 'experts' and public alike. These have resulted in claims of 'economic fundamentals' being ridiculed, and the intrinsic value upon which shares are supposedly based becoming increasingly uncertain. Such overvaluations have usually been 'corrected' by the market. These revaluations have resulted in some of the most disastrous stock market crashes in history, with devastating consequences.
This essay will begin by defining 'bubbles', and then outline two conventional investment theories which are inconsistent with the occurrence of bubbles; fundamental analysis and the efficient market hypothesis (EMH). Two explanations will be offered for the existence of speculative bubbles. The first hypothesis is that markets act irrationally during speculative bubbles due to changing expectations, and emotional decisions. The alternative explanation is that market actions are not determined by traditional economic models; they are determined by a Chaotic model. These explanations will be examined in turn.
Speculative Bubbles
A speculative bubble (a 'self fulfilling prophesy') exists if 'the reason that the price is high is only because investors believe that the selling price will be high tomorrow - when 'fundamental' factors do not seem to justify such a price.' Holland in the late sixteenth century is the earliest example of the havoc which 'irrationality' can play with valuations. The infamous tulip bulb craze occurred when tulip bulbs became more valuable than gold. People sold their land and jewels to buy a single tulip bulb in the expectation that the price would rise yet higher, and capital appreciation would make them rich beyond their dreams. Inevitably, however, tulip prices fell until the bulbs were worthless, and a prolonged depression followed in Holland. The UK had a similar crisis, in the form of the South Sea bubble, in which the stock of a company which traded in the South Seas experienced exponential price increases, leading to 'bubbles'; ingenious and occasionally fraudulent investment opportunities became the craze of the day. The shares plummeted due to a liquidity crisis. The British government consequently passed the Bubble Act, forbidding companies to issue stock certificates.
These events appear to be unusual, surely occurring infrequently? Unfortunately, this is not the case. Similar speculative crazes have occurred in Florida real estate, London real estate, stock markets in the late 1920's, American Blue Chip stocks, commodity markets (silver in particular), growth stocks, concept stocks, junk bonds, conglomerate stocks, New Issues, Biotechnology stocks, and most recently in the stock markets across the globe in 1987. How can such events occur in a supposedly efficient and rational market? Is there no fundamental basis upon which shares are priced?
Fundamental Analysis
Fundamental analysis, broadly speaking, values shares according to three factors; the state of the economy, the state of the industry in question, and the earning power and potential performance of a particular company. Fundamental analysts then look for shares which are, in their opinion, overvalued (undervalued), and then sell (buy) these shares in the hope of making a profit when the rest of the investing public realises the truth of their conclusions. In short, fundamental analysis should ensure that all firms have equal price-earnings ratios. Now, given that arbitrage (that is, the ability to simultaneously buy and sell a commodity in order to make a profit), coupled with abundant amounts of information, should ensure that firms will be priced proportionately, for their expected future dividend yields, can we not assume that prices are therefore generally correct? 'The essence of a correct price is not that it predicts the future, but that it fully captures the uncertainties of the future.' An efficient market should, by this definition, ensure that share prices are correct at all times. It is obvious with hindsight that this has not always been the case. To examine why, we shall first review the efficient market hypothesis.
The Efficient Market Hypothesis
Market efficiency infers that market prices reflect all publicly available information. This includes information about confidence amongst investors and consumers, as well as information regarding the likelihood of future events. Prices react immediately and correctly to new information. Furthermore, changes in share prices will be completely random unless new information is received and assimilated. Speculative bubbles involve persistent deviations from a share's 'correct' value and cannot be deemed random. Are efficient markets consistent with Wall Street crashes? EMH implies that share prices should not increase on the whim of the crowd. To examine how delusion in the stock market can occur, we must thus assume that EMH does not always hold, and examine the basis upon which investors value shares, the efficiency of their actions, and the role of expectations.
Stock Market Valuations
Earnings and returns are the key factors in the market value of an asset. Rational estimates of future earnings are made on the basis of such factors as present earnings, growth potential, industry performance and the current phase of the business cycle. On the basis of all presently available information about a firm, fundamental analysts estimate its future earnings and dividends. On average, according to rational expectations, they will be correct, and they can force the market price to converge with the average opinion. Stock Market crashes may appear to make rational expectations derisive. 'Only a week earlier (Before Black Monday, Oct. 19th, 1987), virtually every big Wall Street firm had been bullish about the market.' On average, Wall Streets' expectations were wrong.
The Effects of Changing Expectations
Why do persistent deviations from a share's (or market index's) fundamental value occur, and why do they take so long to correct? When examining the future return on an investment, common shares offer the prospect of an uncertain stream of income, in the form of dividends, coupled with capital gains. The fundamental value of a share is the expected value of the company's dividends per period, forever. The stock market will ensure, through arbitrage, that the following relationship holds:
r = e(d)/p + p/p.............(1)
p : expected change in the price of the security
p : price of the security
r : interest rate on fixed yield bonds
e(d) : expected future dividends
Subsequently, this security is looked upon more favourably, for no better reason than that other investors are buying the security, or that a tip sheet favours its prospects. The price of the security is expected to rise, which would provide capital gains. Expectations have changed; p has increased to p*.
Assuming that interest rates and dividend expectations are fixed in the short term, the price of the security must increase to maintain the equality:
e(d)/(p+x) + p/(p+x) = r = e(d)/p + p*/p
p* : revised expected change in the price of the security
x : the amount by which the price of the security must change to ensure that the relationship (1) still holds.
The price of the security must increase by amount x to accommodate the buoyant expectations. Merely by increasing the expected future value of the security, the price increased. This is obviously a self-fulfilling prophesy. Is the price of the security 'correct'? If the change in expectations is based on the rational interpretation of new information, suggesting a favourable future state is more probable than was previously believed, then such a change in price is indeed 'correct'. If however, such a change in expectations has occurred without any new significant information appearing on the market, the price either was originally incorrect, is now incorrect, or both. The market is acting irrationally.
Rational Pricing
Rational pricing of securities is of primary importance in economics not merely to indicate the correct wealth of shareholders; it is also 'of critical importance for resource allocation,' and to ensure that prices eventually correspond to their long-run competitive equilibrium. Speculative bubbles indicate that the pricing of securities is irrational. The obvious culprit for such irrationality is the role of expectations in the pricing of securities. Eugene F. Fama, in analysing the 1987 crash from a rational pricing perspective saw that all explanations were 'driven by a change in expectations about conditions.' No reason has been found for expectations to change initially.
In reality, investors are more concerned with the behaviour of their colleagues than with market fundamentals. 'If an ordinary rational investor had good reason to believe that other investors would not behave rationally then it might well be rational for him to adopt a strategy he would otherwise have rejected as irrational.' Stock market crashes could easily result from similar behaviour; if an investor perceives panic, or impending hysteria, he himself will panic. If such behaviour occurs during the building and bursting of speculative bubbles, can we have confidence in security prices in general? Is the determination of security prices truly a 'speculative and anticipatory phenomenon'? During the 1987 Wall St. crash, when $1 trillion of paper money was wiped out in a day, The Economist blamed the 'madness of crowds', and 'mob psychology' for the bull market, and the subsequent crash. As for the belief in fundamental values - 'Just before the stock market crash, commodity analysts were saying that metal prices were rising because of 'market fundamentals'. Come the crash, they threw their fundamentals out of the window, and indulged in old fashioned panic instead.'
We must assume that the irrationality prevalent during speculative bubbles is exceptional, despite the fact that one can construct simple and plausible models of bubbles that never break. One of the greatest problems for economists is that 'there is no scientific way to show that security prices are rational or irrational.' A fundamental assumption of economic theory is that all economic agents act rationally. In the case of speculative bubbles, (and perhaps in many other cases) rationality breaks down, and economic theory goes out the window. This is why nobody will ever satisfactorily explain the Great Depression, Black Monday, or the craze for tulip bulbs.
Chaos Theory
Is there any other theory which could possibly shed some light on the subject of speculative bubbles? Chaos theory may be the answer. Chaotic models, despite the name have a pattern behind the chaos. These models are deterministic mathematical models, (usually non-linear), which explain every nuance of the behaviour of the variables in question. The observations which result from Chaotic models have the following properties.
1 - They appear random (even when subject to sophisticated statistical analysis).
2 - No pattern repeats itself. Thus even with infinite data, no two patterns will ever be exactly alike.
3 - The time series is subject to sharp and substantial breaks in the usual pattern or trend, which are completely undetermined by what went before. Thus, a series of observations with a high degree of volatility and an upward trend can be suddenly replaced by a flat downward trend.
4 - The qualitative behaviour of a Chaotic time series is subject to complete upheaval in response to the most microscopic change in the values of the underlying parameters.
Despite the appearances conveyed by such properties, Chaotic models are non-random, and (given the model) completely predictable. Let us examine the explanative power of such properties in relation to speculative bubbles:
1 - Stock market prices have been found in some empirical studies to be completely random.
2 - Technical analysts cannot systematically beat the market, despite their in-depth study of past patterns.
3 - 'Sharp and substantive breaks'... : The events of 1929 and 1987 fall into this category.
4 - 'Microscopic changes'.... : This could well be the reason why a true cause for Black Monday cannot be found. Could a farmer in New Zealand increasing prices possibly be responsible for a crash in Wall Street? Chaos theory suggests that this is possible.
As we have seen, Chaos theory appears to have strong explanatory power regarding the behaviour of share prices. It is an model of economics which is consistent with historical events, but too complex to be of use in predictions of the future. These sentiments, however, are as yet untested and further empirical research into this area is necessary.
In conclusion, behaviour during speculative bubbles appears to be outside the scope of traditional economic explanation. Although agents may have rational beliefs, they do not always behave in such a manner. To understand the actions of economic agents during bubbles, psychological analysis appears to have greater explanatory power. Alternatively, perhaps by replacing established economic models with a Chaotic model, these events will appear logical. These results portray an unkind picture of the stock market; it is either irrational and inefficient, or ruled by chaos.
Bibliography
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