History, Stories, and Amplification Mechanisms

Fin254f: Spring 2010Lecture notes 2.5

Readings: Shiller 3-7

What is this Section About?

Shiller's qualitative takes on financial bubbles

How do they get started?What makes them really take off?

What mechanisms contribute?

Outline

Precipitating factors in the late 20th century

Amplification mechanismsThe mediaNew era thinking

Precipitating FactorsMostly in the 80's and

90'sCapitalist explosionCultural changes toward businessNew information technologiesSupportive monetary policyThe baby boom and bustBusiness news reportingAnalysts optimism

Precipitating FactorsMostly in the 80's and

90'sInstitutional investment changes Defined contribution pensions (mutual funds)

Hedge fundsLow inflationHigh frequency tradingGambling opportunities

Capitalist Explosion and Ownership Society

Increase in market organized economies

Labor union declines (1983: 20.1% - 2000:13.5%)

Employee stock option plans Greater fixation on stock prices

Cultural Changes Favoring Business

More materialistic measures of worth

Cuts in tax ratesGreater acceptance of large salaries

(Is this all changing?)

New Information Technology

Cell phones (1982) Internet (military -> academic -> everyone)

Earnings growth: 1994 +36%, 8 in 1995, and 10 in 1996

Probably not internet How much should a new technology effect existing firms?

Remember, what matters is public perception

Monetary Policy and the Greenspan Put

No moves to tighten monetary policy in the 90's Interesting given irrational exuberance speech

Several events where liquidity provided (LTCM, Y2K)

Also, did the Fed lower rates too much in 2003?

Baby Boom and Baby Bust

Baby boomers save and drive up stock market Saving bulge : demographic Generation forgets depression

Problems: What about when and how they sell?

What about global demographics?www.hsdent.com

Expansion of Media Coverage

CNBC, CNNfn, Bloomberg TVBusiness news gets "glitzier"Stock tip shows (Cramer)

Analyst Forecasts

Overly optimistic (in 1999 only 1% sell)

Analyst problems Employed by investment banks (underwriting)

Might lose info contacts at firms they rate negatively

Employed by brokers : interest in volume

Some regulatory reform around 2000

Expansion of Defined Contribution Pension

Plans Defined Benefit versus Defined Contribution

Less costly to firms Better for mobile workers Generates more public attention to stocks

How well do people diversity? Bernartzi/Thaler on what people do Equal weight in stock and bond funds and in stock and stock/bond funds

Growth of Mutual Funds

1982: 340, 1998: 3513More equity mutual funds than stocks on NYSE

Start in 1920'sPublic perception rises and falls

Part of 401K investmentsCurrently seem ok, and draws more attention to markets

Decline of Inflation

Lower inflation -> Public confidence

Money illusion Most price series reported in nominal terms

Reporters think inflation too complicated and no one cares

Makes a big difference, two examples U.S. stocks in the 1970's Long term home price series

Online Trading

Etrade and daytrading (internet) Turnover rates double between 82-99

Lower transactions costsDoes this impact a bubble?

Gambling Opportunities

Rise of state lotteriesIncrease in casinosChanges attitudes toward riskCan this spill into the stock market?

Amplification Mechanisms

ConfidenceFeedback

Shiller Surveys

"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."

2000: 97% at least somewhat agree

2004: 83%

Shiller: Real estate as Long Term Investment

See table

Forecasts of Returns: Dow

1989: 0%1996: 4.1%2000: 6.7%2001: 8.4%2004: 6.4%

Confidence Levels Again

See figure 4.1Fraction thinking market is over valued

Compare institutional and individual investors

How do People Process Data?

Recent and distant pastMemory

Feedback

Price -> Buy -> Price -> BuyPrice -> GDP -> Price -> GDPCan we model this?

More on Ponzi

Basic parts Plausible stories High returns Early success : start slow, ramp up

In stocks Story: exaggerated, but not a lie Early price manipulation Draw in crowd

Real Estate and the Stock Market

Stock market "Had no effect on my decision to buy a house" : 72% in 2003-4

News Media

Record overload Superlatives (record everyday)

Stock market moves and big news Tag along news

News tags along as an "explanation" for price moves

Crashes of 29 and 87 New media outlets and rumors

Internet sites

29 in Press

Crash of 29: October 28-29 NYT(29 AM): "general loss of confidence" WSJ(29 AM): "necessitous liquidation of impaired accounts"

President Hoover develops inland waterways

Some news on Smoot-Hawley tariffs, but could that be so big?

Black Thursday, October 24, 1929 Market falls by 12.9%, but then recovers

No real big stories

October 28th/29th 1929

-12.3% and –11.3%

“general loss of confidence in the market and the inability of any man or group to stem

such a torrent of selling.”

October 19, 1987 in the Press

Shiller survey 10 news stories Most important: story about past price declines

Higher than expected trade deficit, possible tax changes

Fires off computerized sell programs (negative feedback)

October 19, 1987

-20.5%

“Worry over dollar and trade deficit”

Feedback Again

Leverage Price falls Borrowed fraction increases Sell off some (deleverage) -> price falls

Short selling Price rise Value of "borrowed" stock increases Need to buy some back to reduce borrowing - > price rise

New Eras

“New economy” 1901

Trains, electricity, new century 1920’s

Electricity, mass production, prohibition Irving Fisher

50’s and 60’s Baby boom, computers, credit cards, macroeconomic policy

New Eras

90’s Globalization Technology Low inflation (macro policy again)

Profits Productivity

Global New Eras

Largest 1 year stock market increases See table 7.1 See also subsequent year patterns

Largest 1 year decreases See table 7.2

Largest 5 year increases See table 7.3

Stories

Philippines: Dec85-86: +683%, Marcos regime collapses. Aquino takes over. Avoids messy civil war.

Taiwan: Oct86-87, +400%, booming exports, double digit growth, shifting to high tech goods, P/E ratios to 45, gambling frenzy, eventually declines by 79% (89-90)

More Stories

Venezuela: 90-91 +384%, recovering economy, oil market uncertainty (Gulf War I), eventually prices fall by 82%

India: April 91-92, +155%, begins large scale deregulation, opens to foreign investment, some price manipulation maybe, falls by -50% next year

Reversals

Do most stock increases reverse?If true, big deviation from random walk.

68% of 5 year winners see price decline in next 5 years

80% of 5 year losers see price increase in next 5 years

Outline

Precipitating factors in the late 20th century

Amplification mechanismsThe mediaNew era thinking

Summary

StoriesAmplifications mechanisms

Price feedback News

Global info Stock market increases (bubbles) common

Most reverse