Lecture 23: Stock Market Booms
and Crashes
Brief History of Booms and
Crashes
• For hundreds of years, speculative markets have
undergone dramatic ups and downs, that appear
irrational to many observers
• Tulipmania, 1630s, Holland
• Mississippi Scheme, 1720, France, John Law’s
Mississippi Company had monopoly of trading for
province of Louisiana.
• South Sea Bubble 1720, England, South Sea
Company had British monopoly on trade in South
Seas
Up-Crashes
• Popular view that markets rise slowly and crash
suddenly is overblown
• January 3, 2001, Nasdaq went up 14% in one day,
following rate cut
• October 6, 1931, Dow went up 14.87% following
President Hoover’s plan for economic recovery
• Biggest 1-day crash October 19, 1987 Dow fell
22.6%, much larger than largest upcrash, but also
twice as big as next largest downcrash
Mackay vs. Garber
• David Mackay, Extraordinary Popular
Delusions and the Madness of Crowds,
1841, popularized these stories of bubbles
• Peter Garber, Famous First Bubbles, 2000,
said Mackay’s bubble stories were not
inconsistent with perfect investor rationality
Efficient Markets Hypothesis
• Stock market level is always unforecastable, not
inconsistent with crashes
• Volatility may be forecastable, and in that sense
crashes may be forecastable
• Efficient markets hypothesis denies the Mackay
theory that something fundamentally irrational is
going on in booms and crashes
• Fundamental disagreement in the finance
profession about how to model markets
Irrational Exuberance
•
•
•
•
•
•
The Stock Market in Historical Perspective
Part 1: Structural Factors
Part 2: Cultural Factors
Part 3: Psychological Factors
Part 4: Attempts to Rationalize Exuberance
Part 5: Tension between Efficient Markets
Theory and Financial Innovation
• The Next Few Decades
The Stock Market in Historical
Perspective
S&P500 Jan 1871-Feb 2004
S&P 500 Price/(10-Year Earnings)
Jan 1881-Feb 2004
Nikkei Index, Jan 1984-Feb 2004
45000
40000
35000
Nikkei Index
30000
25000
20000
15000
10000
5000
0
1980
1985
1990
1995
Year
2000
2005
2010
Germany Dax
Nov. 1990 – Nov. 2003
9000
8000
7000
6000
5000
4000
3000
2000
1000
0
1990
1992
1994
1996
1998
2000
2002
2004
2006
UK FTSE 100
April 1984-Nov. 2003
8000
7000
6000
5000
4000
3000
2000
1000
0
1980
1985
1990
1995
2000
2005
France CAC 40
March 1990- Nov. 2003
7000
6000
5000
4000
3000
2000
1000
0
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
P/E Predicts 10-Year Returns
Price Earnings Ratio Predicting Subsequent Ten-Year Real Returns
Annual January Data, 1881-1990 (1891-2000 returns)
S&P Ten-Year Subsequent Real
Return
20
1919
15
1990
1982
10
1935
1899
5
1914
1929
0
1911
1965
-5
0
5
10
15
20
25
30
35
S&P Real Price / 10-Year Average Real Earnings
40
45
50
One-Year Confidence, USA
Valuation Confidence, USA
Faith in the Stock Market
“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.”
1996
1999
2000
2001-2 2002 2003
1. Strongly agree
69%
76%
63%
60%
46% 39%
2. Agree somewhat
25%
20%
34%
31%
40% 44%
3. Neutral
2%
2%
2%
3%
5%
8%
4. Disagree somewhat
2%
1%
1%
5%
8%
5%
5. Strongly disagree
1%
1%
0%
1%
2%
5%
(Individual investors)
•
•
•
•
•
Historical Intervals between
Normal Years
(Excluding War, Recession)
1. 1871-1891
2. 1891-1913
3. 1913-1928
4. 1928-1950
5. 1950-1964
•
•
•
•
6. 1964-1972
7. 1972-1979
8. 1979-1988
9. 1988-1996
Earnings, Productivity & Value
Grow th over Historical Intervals
15
Grow th Rate (Annual %)
10
Real S&P Earnings
5
Productivity (Gordon Multifactor)
0
1
2
3
4
5
6
-5
-10
Interval Num ber
7
8
9
Real Cumulated S&P Value (w ith
Dividends)
Part 1: Structural Factors
• Precipitating Factors: the Internet, the Baby
Boom, and other events
• Amplification Mechanisms: Naturally
Occurring Ponzi Schemes
Precipitating Factors
• The World Wide Web
• Triumphalism
• Culture Favoring
Business Success
• Republican Congress
& Capital Gains Taxes
• Baby Boom
• Media Expansion
•
•
•
•
•
Optimistic Analysts
401(k) Plans
Rise of Mutual Funds
Decline of Inflation
Expanding Volume of
Trade
• Rise of Gambling
Opportunities
Variations in Factors Since March 2000
• WWW: Dot-com bust weakened faith. Productivity numbers for 1990s
revised down, strong productivity growth since then
• Triumphalism: China 9% growth in 2003
• Republican Congress: Republican James Jeffords defection to
Independent May 2001, Democratic Senate 51-49, back to Republican
senate 51-48 Nov. 2002
• Optimistic Analysts: All major Wall Street firms have announced new
guidelines, HSBC abolishes “hold” recommendation, “equal” buy and
sell. Post-Enron reforms may reduce incentives for optimistic bias.
• Mutual funds: net new flow into stock mutual funds was $32 billion in
2001, compared to $309 billion in 2000, then back up to $69 billion in
year ending February 2004 (all in first two months of 2004).
Amplification Mechanisms
•
•
•
•
Price-to-price
Price-to-gdp-to-price
Price-to-earnings-to-price
Naturally Occurring Ponzi Scheme
Amplification Through
Expectations
• PaineWebber/Gallup Poll: Expect 15.0%
return on stock market over next 12 months
in 1999.
• My polls of individual investors: Expect
4.6% increase in Dow over next twelve
months in 1999.
Part 2: Cultural Factors
• The News Media
• New Era Economic Thinking
• New Eras and Bubbles around the World
Largest Recent One-Year Real
Stock Price Changes
•
•
•
•
•
•
•
•
Philippines 683.4% Dec. 1985-Dec. 1986
Taiwan 400.1% Oct. 1986-Oct. 1987
Venezuela 384.6% Jan. 1990-Jan.1991
Peru 360.9% Aug. 1992-Aug. 1993
Colombia 271.3% Jan 1991-Jan. 1992
Jamaica 224.5% Apr. 1992-Apr. 1993
Chile 199.8% Jan. 1979-Jan. 1980
Italy 166.4% May 1985-May 1986
Part 3: Psychological Factors
• Psychological Anchors for the Market
• Herd Behavior and Epidemics
Prominent Psychological Theories
• Anchors: Kahneman & Tversky Wheel of
Fortune experiment
• Overconfidence
• Attention Anomalies
Part 4: Attempts to Rationalize
Exuberance
• Efficient Markets, Random Walks, and
Bubbles
• Investors’ Learning — and Unlearning
Price and Dividend Present Value
1600
1400
Real S&P Composite Index
1200
1000
800
600
400
Dividend Present
Value
200
0
1860
1880
1900
1920
1940
1960
1980
2000
2020
Irving Fisher 1929
“It was only as the public came to realize,
largely through the writing of Edgar
Lawrence Smith, that stocks were to be
preferred to bonds during a period of dollar
depreciation, that the bull market began in
good earnest to cause a proper valuation of
common shares.”
The Crash of 1929
• Complete absence of news
• Smoot-Hawley Tariff not news
• Sequence of events led to bottom 1932
The Crash of 1987
• Lawrence Harris, “The October 1987 S&P
Stock Futures Basis
• Futures price too low to be explained by
nontrading lags in index
Questionnaire Survey Oct 1987
• Average time individuals heard of the crash,
1:56pm EDT (10:56am PDT) October 19,
1987
• Average individual spoke to 7.4 other
individuals about stock market that day
• 81.6% of individuals heard about the crash
before 5pm
Ranking of Importance of News
Stories
1. The 200-point drop of the Dow that
morning 5.14 (on 1-7 scale)
2. Drop in Dow October 14-16 4.54
3. Treasury bond yields hit 10.5% 4.27
4. Trade deficit figures 4.21
5. Chemical bank raises prime rate 4.14
6. Baker suggesting dollar should fall 4.04
Psychology or Fundamentals?
• Which of the following better describes
your theory about the declines: a theory
about investor psychology or a theory about
fundamentals such as profits or dividends
– Psychology 67.5% individuals, 64.0%
institutional
1987: Investors Thought They
Knew What Will Happen
• “Did you think at any point on October 19,
1987 that you had a pretty good idea when a
rebound was to occur?”
-Individuals 29.2% yes, Institutions 28.0%
yes
If Yes, why?
-gut feeling, intuition, market psychology,
common sense, story telling
The Nikkei Crash after 1989
•
•
•
•
•
Nikkei peaked last day of 1989, nearly 40,000
Has remained below half that since
High expectations for Japanese economy in 1980s
Bubble Economics, Yukio Noguchi 1992
Many reasons for slow growth in Japanese
economy since then, but tend to be related to
bubble situation in 1980s
• Nikkei 1989 a model for Dow 2000?
Samuelson’s Dictum
• Market Efficiency Theory Has Some Merit
• Samuelson’s Dictum: Some evidence of
micro efficiency and macro inefficiency
Present Value of Dividend Changes
Plotted Against D/P Ratio
1.5
dividend growth
1
0.5
0
-0.5
0
0.1
0.2
0.3
D/P ratio
0.4
0.5
Part 5: Tension Between Efficient
Markets Theory and Behavioral
Finance
• Aggregate markets are not very efficient
• Investors make many systematic mistakes
• And yet, financial markets matter very
much for economic success
• All successful economies have sophisticated
financial institutions
Concluding Thoughts
The Next Few Decades
• The most exciting prospect: the developing
world catches up
• Financial Markets will be everywhere,
dominating people’s lives
• Financial booms and crashes will be even
bigger than before
• Worse things have happened in history!
Dramatic Change in Finance, our
Economy
• Experience of last century suggests
dramatic changes in the next
• Information technology unleashes a cascade
of other changes in the economy
• Other technology transforms the world
economy, creating opportunities and
challenges
Risk and Chance over Careers
• Century-long personal outlook
• Reflections on upheavals in last century
• Stock market risk is compounded by
individual career risk
• Illusion of invulnerability
Ecclesiastes IX 11
“I returned and saw under the sun that the
race is not to the swift, nor the battle to the
strong, neither yet bread to the wise, nor yet
riches to men of understanding, nor yet
favour to men of skill; but time and chance
happeneth to them all.”
Career Risks
• Joshua Angrist, Analysis of draft lottery,
1969. Low RSN lowered income decade
later by 15%
• Over half of the cross-individual variance in
incomes cannot be explained either by age,
schooling, experience, parents income,
parents occupation, or transitory component
[Bowles et al. JEL Dec. 2001]
A Risky World
• Media focus on success
• Longer-run perspective: people in positions
come and go by chance
• Careers and economic success “come
together” by the strangest coincidences
Human Capital, Positioning, and
Meaning
• Maintain an orientation towards history in
the making, rather than to one’s own point
in the life cycle
• Maintain human capital, strategically
oriented
• Maintain humanity in an unforgiving
business world
Don’t Sell your Textbook