Market Efficiency and Bubbles

1. Market Efficiency and Bubbles Economics 71a: Spring 2007 Lecture notes 4.9 Malkiel: 6-8, 11

2. Outline • Bubbles • Market efficiency • Final advice

3. Bubbles (some examples) • Tulips • South Sea • US Stocks 29 • US Stocks 60’s • Japan (80’s) • Internet (90’s)

4. Tulips • Holland 1593-1637 • Tulips infected with virus • Causes spectacular colors in infected tulips • These are relatively rare

5. Prices • Tulip prices soar • Everyone gets interested in the tulip craze • Half pound of Witte Croonen went from 64 guilders 1/2 lb to 1668 from Jan to Feb 5th 1637 • Back to 37 in 1642 • One Semper Augustus goes for $50,000 worth of gold

6. The end: 1637 • Bulb prices collapse • Holland goes into a recession • Was it a bubble, compare to today? • Mass hysteria • Prices moving for no apparent reason

7. South Sea Bubble • England early 1700’s • South Sea company given trade monopoly rights • Company issues stock, but it is not able to make money • Meanwhile in France • Mississippi company starts • Large conglomerate • South Sea stock takes off

8. The end of South Sea • August 1720 • Directors of South Sea Sell • Panic • Government forbids stock certificates until 1825

9. Fun Quote: Sir Isaac Newton • Newton was one of the losers in the South Sea Bubble • “I have learned to predict the movement of celestial bodies but not the movement of man in markets.”

10. 3. The Crash of 29 • March 1928-Sept 1929 • Market increase equals 23-28 • Everyone gets involved

11. Two features • Margin purchases • Buying on credit • Investment Pools • Build group • Trade stock amongst selves • Release good rumors about the stock • Start a stampede, then get out

12. The Peak • September 3, 1929 • Prices would not be this high for 25 years • Economic activity slowing • Fed had been contracting the money supply since 1928 • Trying to pop the bubble

13. Most Famous Quote • In Sept. 1929, Irving Fisher of Yale, (inventor of intrinsic value, what we’ve just been doing) • “stocks have reached what looks like a permanently high plateau” • Comments on new “economy” • Electricity • Prohibition

14. Big trouble begins • Monday, October 21st • Market falling • Volume huge • Tickers running behind trades • October 28, 1929 • Fall of 15% • October 29, 1929 • Fall of 12% • About 40 points, and 30 points

15. Crash of 29 and AfterNote where the big drops occur

16. Crash of 1987 • October 19, 1987 • Features • Largest one day point drop • 508 points • % change = 22.6 • Huge volume, system overloads • Portfolio insurance

17. Federal Reserve Behavior During the 1987 Crash • Definition: Systemic Risk • Financial meltdown • Chain reaction • Borrowers default • These defaults cause another set of borrowers to default • ….. • Financial system “melts down” • Federal Reserve concerned about this

18. Fed Behavior During the 1987 Crash • With large fall in prices many in trouble • Fed opens short term credit lines • Lender of last resort • After crisis monetary policy tightens • Modern connections: • Long Term Capital Management • Asian crises • Sept 11th

19. Years around 1987: Dow Level

20. Japan: 1990’s

21. Japan Land Bubble • 55-90 Land goes up 75 times • 1990 Japan land 5 times the value of all U.S. land • Value of Imperial Palace = California • Firms use land holdings as collateral • “Japan is different”

22. Comparing 30’s, 87, Japan, and 2002 • 1929-32: Total drop 77% • Japan: Total drop 63% • Plus land • 1987: Drop = 20% • Erased in 2-3 years • 2002: Drop off peak • S&P 500: 50% • NASDAQ: 80%

23. Internet Bubble (90’s)

24. S&P500 versus NASDAQ

25. Yahoo

26. Ebay

27. Amazon

28. Amazon versus NASDAQ

29. Amazon versus P/E Ratio

30. Google versus P/E Ratio

31. Odd Pricing • Market value of Amazon greater than all publicly owned bookstores • Priceline.com market value greater than Delta, United, and American combined

32. AOL/Time Warner • Unusual merger in 2000 • Mostly AOL stock • Synergies??? • Worlds largest media company • AOL removed from name in 2003

33. Bubble/Hysteria Summary • Markets can go out of control • Be watchful for hysteria and outright fraud • However: • Hysteria hard to detect when going on • Hard to “swim the other way” • Malkiel • Markets still basically efficient

34. Outline • Bubbles • Market efficiency • Final advice

35. Efficient Market Hypothesis • Weak-Form Efficiency • Prices reflect all market related information (prices/trading volume) • Semistrong-Form Efficiency • Prices reflect all publicly available information (accounting fundamentals) • Strong-Form Efficiency • Prices reflect all public and private information

36. An EMH paradox • If we believed that markets were efficient, then we wouldn’t waste any time looking for predictability • There would be no one around waiting to eliminate predictability that might occur

37. However, • A key feature of almost all financial markets is that they are rather difficult to predict!

38. Efficient Markets (Defined Again) • Risk/Return • Fair world • Information • Prices reflect all information • Markets efficiently aggregate judgements

39. Risk versus ReturnEfficient Market View: Investment Opportunities Return * * * * * * * Risk

40. Investment Strategies and Market Efficiency • Technical analysis • Fundamental analysis • Implementation • Stock selection • Market timing • Index funds

41. Efficient Markets Side • Markets not perfect, but • Markets are still pretty hard to forecast • Who are the “smart people” making money off all the inefficiency? • Mutual fund evidence (Malkiel)

42. My Thoughts on Market Efficiency • Perfect efficient market world is wrong • Pockets of inefficiency • Can you capitalize on them? • Do they affect the economy?

43. Three Perspectives • Individual investor • Should you try to beat the market? • Professional investor • Are there places where the full time professional can add value? • Policy makers • Do market excesses disrupt other parts of the economy? • Internet bubble • Real estate in 2007