2008 May 20 Tuesday
Why Financial Asset Bubbles Happen

An interesting article in the Wall Street Journal reports on economics researchers at Princeton University who believe market bubbles are caused by conditions that allow the optimists to get the upper hand in driving up asset prices.

Mr. Hong, who came to Princeton two years later, and now is 37, argues that big innovations lead to big differences of opinion between bullish and bearish investors. But the deck is stacked in favor of the optimists.

One who believes a stock is too high can short it, borrowing shares and selling them in hopes of replacing them when they're cheaper. But this can be costly, both in the fees and in the risk of huge losses if the stock keeps rising. Many big investors rarely short stocks. When differences between bullish investors and bearish ones are extreme, many of the bears simply move to the sidelines. Then, with only optimists playing, prices go higher and higher.

Look at Warren Buffett. He's an investment genius. But he rarely tries to make money on falling markets. Bubbles seem like a sign of inefficiency in markets due to flaws in human cognitive processing.

Now Federal Reserve chairman Ben Bernanke recruited many of these researchers while he was at Princeton. So Bernanke obviously understands we are dealing with the popping of yet another bubble.

The debt taken on to drive up prices of assets means that when the downturn comes previously optimistic investors are forced to sell by their needs to raise money to service debt obligations. That makes the downward path steeper than the upturn that preceded it.

At some point in a bubble, optimists' enthusiasm runs its course. Prices turn down. There's an expectation that at this point, investors who were skeptical may see prices as more reasonable and start buying. If they don't, that's a signal that prices had gotten way too high -- and then they tumble.

The insights of bearish investors "are more likely to be flushed out through the trading process when the market is falling, as opposed to when it's rising," Mr. Hong and Harvard's Jeremy Stein write. They say this explains why prices fall more rapidly than they go up. Over 60 years, nine of the 10 biggest one-day percentage moves in the S&P 500 were down.

When a lot of borrowed money is involved -- as it often is in a bubble -- once prices peak, the speed of their fall is intensified as investors sell urgently to pay down debt. That pattern offers a strong argument, in Mr. Hong's view, for government to restrain bubbles and the borrowing that fuels them.

Bubbles can turn a profit for those who do not believe the Panglossian rhetoric of bubble boosters. During the 1990s dot com tech bubble some hedge funds skillfully played both the run-up and the collapse of tech stock prices.

Looking through security filings, Mr. Brunnermeier and Stanford's Stefan Nagel found that hedge funds on the whole "skillfully anticipated price peaks" in individual tech stocks, cutting back before prices collapsed and shifting into other tech stocks that were still rising. Hedge funds' overall exposure to tech stocks peaked in September 1999, six months before the stocks peaked. They rode the bubble higher and got out close to the right time.

Unfortunately the high commodity prices of today do not show signs of being part of a commodities bubble. So we aren't going to get back to cheaper commodity prices just by hitting the limits of a bubble.

Today, there's disagreement over commodity prices: to what extent do they reflect fundamentals like Chinese demand, and to what extent investment mania? Trading points toward a bubble: Daily volume on crude-oil contracts is running 50% above last year. Yet the initial findings of work Mr. Hong has done with Motohiro Yogo of the Wharton School -- comparing cash prices and futures prices -- suggest that "prices for commodities are expensive," but not a bubble, Mr. Hong says.

Share |      By Randall Parker at 2008 May 20 05:17 PM  Economics Business Cycle


Comments

Post a comment
Comments:
Name (not anon or anonymous):
Email Address:
URL:
Remember info?

      
 
Web parapundit.com
Go Read More Posts On ParaPundit
Site Traffic Info
The contents of this site are copyright