Speculative Bubbles, Manias and Crashes

1. Alessandro Di Trapani Terri Haarburger Raeesa Mohamed BonganiNgwenya AmukelaniShilubane Speculative Bubbles, Manias and Crashes

2. Introduction

3. Tulip Mania • Illustration of speculative excess • Contract prices for the bulbs were extraordinary • First recorded speculative bubble • Netherlands was a highly commercialized country • Dutch dominated tulip market

4. Tulip Mania • Single bulb = 4oxen +8 swine +12 sheep +£1000 cheese +Measures of wheat, rye, beer and butter +Bed +Suit +Silver cup

5. Tulip Mania • Final speculative frenzy • Large amount of foreign funds • People hurriedly liquidated assets to be able to participate • Possible causes: • Bubonic plague • Formal future contracts required no margin • Consequences • Growers of bulbs left to absorb majority of the damage

6. South Sea Bubble • Disaster came about by bribery, corruption, robbery and jobbery • Sought a rapid expansion • Did so by acquiring British government debt • Of £50 million of British Debt, South Sea held £11.7 million • To finance debt, South Sea was permitted to expand the number of shares • Difference between par and market value

7. South Sea Bubble • Began to talk up its stock, which was followed by a wave of speculating frenzy. • Feeding of capital into Royal Assurance Co and the London Assurance Co • Bubble Act in June 1720 • Immediate downward pressure was placed on the price of shares of the effected companies. • Due to these shares mostly being held on margin; general selling hit the shares of all companies • International scramble for liquidity

8. Stock market crashes • Wall Street Crash of 1929 • The Dot.Com Bubble • The Sub-Prime Mortgage Crisis: The 2008 Recession

9. Wall Street Crash of 1929 • Most devastating crash in the history of the US • Signaled the beginning of the 12 year Great Depression

10. Wall Street Crash of 1929

11. Wall Street Crash of 1929 • Causes: • Speculation • Expansion of investment trusts, public utility holding companies • Margin buying • Economic fundamentals

12. Dot.Com Bubble • A decade into the 21st century – lessons learnt? • Dot.Com bubble can at least be credited with the honourofcatapultingsociety into the modern technological age. • Transformation of academic network to commercial colossus – Netscape.

13. Dot.Com Bubble • Netscape’s browser interface • 3 million downloads in three months • ensuring its place in the record books on popularity grounds. • The perfect start to the madness • Netscape lists on the Nasdaq Composite. • Share prospectus, supply and demand, market clearing price and closing price.

14. Dot.com bubble in the making • Expansionary monetary policy. • Economic and political influence. • Technology indicators started showing signs of increase and investor optimism gained traction.

15. Dot.com bubble in the making • In 1999 the Nasdaq Composite rose by 80% in that year alone. • Tech IPO were springing up left and right – Callahan’s Summation (2003) • KUO (2001) provided examples, iVillage and Autobytel.

16. Dot.Com Source: www.dailyfinance.com • 2700 in September 1999 to a level in excess of 5000 by mid March 2000 = 80% in six months. • Reality began to sink in for lenders, tech startups and the Federal Reserve Bank.

17. The Pin Prick • Federal Reserve finally tightens the economy’s purse strings, in the early 2000’s. • Massive price corrections seen above signalled that reality had finally bitten back.

18. History Repeats Itself… • Sub prime crisis. • Mortgage- backed security. • Federal Reserve, pricing disqualified parties in to the market. • US Home Ownership rate peak.

19. History Repeats Itself… • Investment banks become involved in the mortgage market. • As much as 60% – 80% of all mortgages underwritten in the period were defective. • As much as 40% of those were securitised and sold off to investors.

20. Houses For All Comers

21. The Financial Crisis in Context

22. The Aftermath • Top 5 Investment banks and Leverage ratios. • The fate of Lehman Brothers. • Bear Sterns and Merryl Lynch sold at fire-sale prices. • Goldman Sachs and Morgan Stanley became commercial banks. • In conjunction with Freddie Mac and Fannie Mae • US$9 trillion in debt and guarantee obligations, • yet not subject to the same regulation as depository banks.

23. South African Perspective • Found not be at risk of a major backslide (Massa and teVelde, 2008) • Commended by the IMF (December 2010) • Escaped the Wrath of the American • Subsequently world-wide sub prime flu. • South Africa’s continuing efforts • To remain in line with financial standards • And impose strict regulations of its own • Contributed to the strength and stability of the South African banking and investment systems.

24. Bubbles and The EMH

25. Bubbles and The EMH

26. Bubbles and The EMH • Efficient Market Hypothesis • Efficient markets consisting of rational investors • Strongest form • Security prices reflect ALLsecurity market information • Private and public information • Bubbles = Prices above intrinsic value • Not consistent with EMH • Any deviation from intrinsic value will be arbitraged away

27. The EMH • Assumes investors are: • Fully rational • Unaffected by emotions and the actions of others • BUT: Investors are humans! • Humans do occasionally behave irrationally! • Irrational behaviour most evident during a bubble

28. “Less-Than-Rational” Behaviour • Looking back at a bubble, irrationality is obvious • However, at the time investors did not think they were being irrational • Shiller (2002) • Existence of a bubble is based around less-than-rational behaviour from investors and not foolishness • Even “experts” were wrong about the market and asset price valuation

29. Rational Bubbles • Blanchard and Watson (1982) • Bubbles and Rational Behaviour can co-exist • Rational Arbitrageurs • Aware that securities are overvalued and that the market will eventually collapse • Ride the bubble • Generate high returns • Get out just before the bubble bursts

30. Rational Bubbles • Rational Arbitrageurs • Varying views/information about the bubble and when it will burst • Lack of synchronisation • Bubble bursts due to selling pressure when a sufficient amount of investors sell their positions • Therefore, the more dispersed the opinions of rational arbitrageurs, the longer it takes for mass “sell out” to occur

31. Rational Bubbles • Favour Behavioural view over EMH • Rational Arbitrageurs • Acknowledge the mispricing and fuel it further only to sell just before the bubble bursts • Optimal strategy for them, provided they get out at the right time • Whereas EMH assumes that mispricing will immediately be arbitraged away.

32. The EMH – “A Half Truth?” • Shiller (2002) • Semi-Strong form of EMH most widely accepted • Current security prices fully reflect allpublicinformation • Active portfolio strategy based on fundamental analysis is useless • Therefore, passive strategy (indexing) would be the superior option for the investor • Less transaction costs and time

33. The EMH Paradox • If all investors believed that the market was efficient and active strategies were useless • No investors doing fundamental analysis • Nobody making sure that securities are correctly priced • “Arbitrageurs” defined by the EMH that would correct any mispricing would not be looking for those mispricing

34. EMH Fuelling Bubbles? • For every analyst warning about overvaluation and the possibility of a bubble • There is the EMH and its supporters saying that the market could not be far out of line • Calverly (2009) • Used example of the 1990’s stock bubble • EMH supporters claimed that the market was always “correct” • Helped to reduce the sense of risk among investors

35. Are Markets Efficient? • The existence of bubbles and the associated irrationality decrease credibility of the EMH • Malkiel (2005) • Reckless to disregard the EMH all together • Supports market efficiency by using evidence from the past performance of active and passive investment strategies • market index, on average, consistently outperforms actively managed funds • i.e. markets are efficient in reacting to information

36. Summing up on the EMH • Shiller (2003) • Emphasises the importance of distancing ourselves from the ideas that: • markets always work perfectly • price changes always accurately reflect the relevant information. • Short-term deviations from Market Efficiency • Irrationality and inefficiency overcome the ideals of the EMH • Psychological and behavioural factors play a part in investment decisions • Eventually the bubble will pop

37. Psychological Factors • Stock markets are influenced by consumer behaviour • Investors are NOT rational! • Uninformed investors: • Overreact to information • Extrapolate past trends • Overconfident

38. Momentum • Momentum trading: • stock price changes will prevail in the future • And continue moving in the current direction • Shares rise above fundamental value • Self-fulfilling prophecy • Believe prices will increase therefore invest more • Invest more because prices are increasing

39. Momentum

40. Social Mood • Social Mood: • How investors and corporate managers react to changes in the stock market depending on their mood • Optimistic • Increase spending • Additional debt • STOCK MARKET BUBBLE • Pessimistic • Lower risk • Stock market declines and more volatile

41. Social Mood • Reasons • Assume bubble will inflate indefinitely • Moods trends herd behaviour • Emotional decisions • Severe optimism • BUT eventually… • Optimism dwindles • Cognitive decisions • Leads to STOCK MARKET CRASH

42. Herding • Herding: • following other investors without considering their own information • Strongest when uncertain • Act on an informational spill-overs • consider other investors’ actions as providing information and then act on that information. • This leads to the share price movements becoming detached from appropriate information

43. Herding • Strongest when • Expectations are alike, persistent and slow moving • Investors are confident in the direction market is heading • Supports theory that speculative bubbles may take years to develop • May be following uninformed or irrational traders • Rational investors: • Disregard fundamentals • Focus on investors behaviour

44. Herding • Media • Focus for long periods on very good or very poor companies • Leads to speculative bubbles and crashes • Herding occurs: • To increase survival • Because assume other investors know better • Herding causes stock market to be overpriced • STOCK MARKET CRASH

45. Overconfidence

46. Greater Fool Theory • Greater Fool Theory: • Ignore fundamental value • Invest as long as ‘greater fool’ willing to pay a higher price • Assume prices will continue to rise • Rational investors • Expected gains > expected losses

47. Greater Fool Theory • Violates EMH • Prices are correlated • Past movements do matter • Overvalued prices • Causes STOCK MARKET BUBBLE

48. Are We in a Speculative Bubble? • Irrational exuberance in Internet world • Overvaluation of: • Private companies • Anything related to China • Optimists • Technology landscape has changed • No widespread mania • China could cause the next bubble burst • Political risks • Web investors should proceed with caution