The formation of a bubble starts with the clear and continuous rise of share prices caused by an exogenous shock affecting the economy. This initial displacement influences future outlook in a positive way, generating expectations of further rise. If share prices distinctly begin to rise, uninformed investors, partly due to the deduction problem, take this as a positive signal. Share of particular industries and companies may become popular. New buyers appear in the market and the proportion of shares increases within portfolios causing a surge in trading volume. As many investors are pursuing a positive feedback strategy, this coupled with the lack of relevant information will amplify noise trading.
A stock market boom can be described as a bubble if there is high probability of a large scale fall in share prices. Stock market crash is not triggered by fundamental news or by a certain level of share overvaluation. Instead, it happens because of a drastic change in the behavior of market players. This is why the necessary and sufficient conditions for the bursting of a given asset price bubble, applicable in practice, cannot be provided with the tools of mathematical economics. A market crash will ensue with a high likelihood if noise trading becomes dominant, the signals of which are to be found in the following stochastic factors:
• Increasing effect of leverage. As a direct consequence, more money is at the disposal of investors. If investors borrow to buy shares, have the opportunity to postpone payment, or making a purchase without full financial cover, it is impossible for them to realize long-term profit on that particular stock, i.e., they are unable to make dividend payment. This means a short sale constraint shortening the average investment period. The due date of debt repayment is private information incurring, on the one hand, deduction problem and noise trading. On the other, if there is an increasing pool of leveraged shareholders, repayment date and a short sale constraint will more likely be due at a given moment, amplifying the degree of the price fall.
• Increasing activity on part of the economic policy. Economic policy, and monetary policy in particular, can directly influence the conditions of credit, bond and money markets connected to stock markets, thus making the state a protagonist in the stock market. Intended monetary expansion or restriction is always a signal, as it attempts to stimulate or curb the rise of prices. For example, the frequent and tendentious revisions of the base rate convey a series of signals towards market players. In theory, the opportunity cost of shares (the rise in bond yields) prompts investors to lower the share of stocks in their portfolios. Sometimes, however, investors are late and inaccurate in integrating signals of the economic policy into their expectations, increasing the volume of noise in the market.
• Increasing number of corporate scandals, fraud and corruption. Share price rise augments the power and influence of executives, while directly affecting their wealth through managerial stock options. Information asymmetry enables them to use methods verging on fraud to maintain the trust of owners-shareholders if corporate performance is not contributing positively to the share price. The disclosure of such cases may undermine trust, causing a change in investor behavior and prompting the sales of the shares of other companies.
• Fundamentally unjustifiable co-movement of share prices. The co-movement of different shares or investments may signal a dominance of noise trading. When investors do not evaluate a given asset based on its expected future yield, i.e., do not evaluate an enterprise based on the probability of its future success, and instead they make simplifications and use rules of thumb, a fundamentally unjustifiable share price co-movement may ensue. If this co-movement increases, price fluctuation may signal a dominance of noise trading, forecasting a stock market collapse.
The last characteristic of stock market bubbles is that the boom and subsequent crash must have an impact on the economy. Only then will the natural instability of stock markets become a factor affecting economy, without which the concept of a bubble would be weightless. By negative impact we mean a slowdown in economic growth or a decline in consumption and/or investment.
However, a bubble may carry positive impacts as well which display themselves either during the boom or following the crash, in the long run. One such effect is the facilitation of capital issue for a given industry allowing a better financing of riskier solutions and developments. After a crash, the framework surrounding the stock market may also change, bringing about legal, regulatory and institutional evolution as a consequence of the collapse. If a stock market boom has no impact on the economy of a country or on related regulation and institutional structure, we contest such a phenomenon can be called a bubble.
Initial displacement, distinct price rise, new buyers (increasing trade volume) all are direct traits of a bubble, while leverage, the large number of economic policy signals, corporate scandals, fraud and corruption are indirect indicators of the phenomenon.
http://www.stockmarketbubbles.com/anatomy.pdf
Chapter 2.2 Page 79
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