Proponents of market irrationality have pointed to market bubbles as a primary exhibit in their case against efficient markets. Through the centuries, markets have boomed and busted, and in the aftermath of every bust, irrational investors have been blamed for the crash. As we will see in this section, it is not that simple. You can have bubbles in markets with only rational investors, and assessing whether a bubble is due to irrational investors is significantly more difficult than it looks from the outside.
As long as there have been markets, there have been bubbles. Two of the earliest bubbles to be chronicled occurred in the 1600s in Europe. One was the amazing boom in prices of tulip bulbs in Holland that began in 1634. A single Tulip bulb (Semper Augustus was one variety) sold for more than 5000 guilders (the equivalent of more than $ 60000 today) at the peak of the market. Stories abound, though many of them may have been concocted after the fact, of investors selling their houses and investing the money in tulip bulbs. As new investors entered the market in 1636, the frenzy pushed up bulb prices even more until the price peaked in early February. Figure 7.11 presents the price of one type of bulb (Switzers) in January and February of 1637.
A rational bubble sounds like an oxymoron, but it is well within the realms of possibility. Perhaps the simplest way to think of a rational bubble is to consider a series of coin tosses, with a head indicating a plus day and a tail a minus day. You would conceivably get a series of plus days pushing the stock price above the fair value, and the eventual correction is nothing more than a reversion back to a reasonable value. Note too that it is difficult to tell a bubble from a blunder. Investors in making their assessments for the future can make mistakes in pricing individual assets, either because they have poor information or because the actual outcomes (in terms of growth and returns) do not match expected values. If this is the case, you would expect to see a surge in prices followed by an adjustment to a fair value. In fact, consider what happened to gold prices in the late 1970s. As inflation increased, many investors assumed (incorrectly in hindsight) that high inflation was here to stay and pushed up gold prices accordingly. Figure 7.13, which graphs gold prices from 1970 to 1986, looks very much like a classic bubble, but may just indicate our tendencies to look at things in the rear view mirror, after they happen.
There are some researchers who argue that you can separate bubbles from blunders by looking at how prices build up over time. Santoni and Dwyer (1990), for instance, argue that you need positive two elements for a bubble �
- positive serial correlation in returns and
- a delinking of prices and fundamentals as the bubble forms.
One or the more fascinating questions in economics examines how and why bubbles form and what precipitates their bursting. While each bubble has its own characteristics, there seem to four phases to every bubble.
Most bubbles have their genesis in a kernel of truth. In other words, at the heart of most bubbles is a perfectly sensible story. Consider, for instance, the dot.com bubble. At its center was a reasonable argument that as more and more individuals and businesses gained online access, they would also be buying more goods and services online. The bubble builds as the market provides positive reinforcement to some investors and businesses for irrational or ill-thought out actions. Using the dot.com phenomenon again, you could point to the numerous start-up companies with half-baked ideas for e-commerce that were able to go public with untenable market capitalizations and the investors who made profits along the way.
Once a bubble forms, it needs sustenance. Part of the sustenance is provided by the institutional parasites that make money of the bubble and develop vested interests in preserving and expanding the bubbles. Among these parasites, you could include:
Brokers and analysts: A bubble generates opportunities for brokers and analysts selling assets related to the bubble. In fact, the ease with which investors make money as asset prices go up, often with no substantial reason, relegates analysis to the backburner.
Portfolio Managers: As a bubble forms, portfolio managers initially watch in disdain as investors they view as naive push up asset prices. At some point, though,, even the most prudent of portfolio managers seem to get caught up in the craze and partake of the bubble, partly out of greed and partly out of fear.
Media: Bubbles make for exciting business news and avid investors. While this is especially noticeable in the dot.com bubble, with new books, television shows and magazines directly aimed at investors in these stocks, even the earliest bubbles had their own versions of CNBC.
In addition to the institutional support that is provided for bubbles to grow, intellectual support is usually also forthcoming. There are both academics and practitioners who argue, when confronted with evidence of over pricing, that the old rules no longer apply. New paradigms are presented justifying the high prices, and those who disagree are disparaged as old fashioned and out of step with reality.
All bubbles eventually burst, though there seems to be no single precipitating event that causes the reassessment. Instead, there is a confluence of factors that seem to lead to the price implosion.
- The first is that bubbles need ever more new investors (or at least new investment money) flowing in for sustenance. At some point, you run out of suckers as the investors who are the best targets for the sales pitch become fully invested.
- The second is that each new entrant into the bubble is more outrageous than the previous one.
In the aftermath of the bursting of the bubble, you initially find investors in complete denial. In fact, one of the amazing features of post-bubble markets is the difficulty of finding investors who lost money in the bubble. Investors either claim that they were one of the prudent ones who never invested in the bubble in the first place or that they were one of the smart ones who saw the correction coming and got out in time.
Note that most investors think of bubbles in terms of asset prices rising well above fair value and then crashing. In fact, all of the bubbles we have referenced from the tulip bulb craze to the dot-com phenomenon were upside bubbles. But can asset prices fall well below fair market value and keep falling? In other words, can you have bubbles on the downside? In theory, there is no reason why you could not, and this makes the absence of downside bubbles, at least in the popular literature, surprising. One reason may be that investors are more likely to blame external forces � the bubble, for instance � for the money they lose when they buy assets at the peak of an upside bubble and more likely to claim the returns they make when they buy stocks when they are at the bottom of a downside bubble as evidence of their investment prowess.
Based upon our reading of history, it seems reasonable to conclude that there are bubbles in asset prices, though only some of them can be attributed to market irrationality. Whether investors can take advantage of bubbles to make money seems to be a more difficult question to answer. Part of the reason for the failure to exploit bubbles seems to stem from greed �even investors who believe that assets are over priced want to make money of the bubble � and part of the reason is the difficulty of determining when a bubble will burst. Over valued assets may get even more over valued and these overvaluations can stretch over years, thus imperiling the financial well being of any investor who has bet against the bubble. There is also an institutional interest on the part of investment banks, the media and portfolio managers, all of whom feed of the bubble, to perpetuate the bubble.