Bubbles in stock markets

‘The stock market’s movements are generally consistent with rational behaviour by investors. There is no need to invoke fads, animal spirits, or irrational exuberance to understand the movements of the market.’ Discuss in relation to the information technology bubble and its collapse.

Introduction

In a perfectly efficient market, it is assumed that all investors have access to all available information of future stock prices, dividend payoffs, inflation rates, interest rates and all other economic factors that affect the present prices of stocks. All investors are perfectly rational and choose to invest in stocks which will have a positive payoff. Therefore, all financial assets must always be priced correctly. Any apparent deviations from the correct pricing for stocks, according to the efficient market theory, must be an illusion, and no gains can be made from arbitrage. In short, all stock prices should reflect genuine and fundamental information about the value of the stock in question. There would be no need to explain changes in price by invoking fads, animal spirits and irrational exuberance.

By this theory, stock prices corrected for a time trend should follow a random walk through time, as any changes are only due to new information, which by definition cannot be predicted in previous periods.

Most empirical studies using data on a stock market to test whether stock prices follow a random walk has been statistically rejected. Also, from a non-specialist point of view, it is easy to find examples in history where stock prices seemed not to have followed a random walk, the dotcom boom of the late 90s being an often-quoted example.

The idea of an efficient market is very natural. From observation, it doesn’t seem easy to make lots of money by buying low and selling high, just as many investors fail on the stock market as succeed. If certain ‘smart’ investors can find ways to make profits on the stock market by buying low and selling high, then, according to theory, they will drive asset prices to their true values; by buying under-priced assets they will drive up those prices, by selling over-priced assets they will drive down those prices. Also, if there were substantial mispricing of assets, the ‘smart’ investors should make ...

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Irrational Exuberance and the Dotcom Bubble

It is almost impossible to distil the factors that contributed to the dotcom bubble. I think there at least some of the causes must originate from a rational framework, but I also think that they alone are not convincing enough; one has to invoke some irrational exuberance in order to explain the bullish stock market during the late 90s.

Psychological experience shows that there are patterns of behaviour in the stock market which cannot be contributed to ignorance, but which nevertheless cannot be classed as rational behaviour. People tend to use past prices as anchors for predicting present prices, so when certain shares are seen as valuable, people tend to regard them as increasing in value. This obviously creates a feedback loop, leading to the bubbles. Also, herd behaviour can dictate how an individual will react. People tend to follow their contemporaries, because we all find it difficult to doubt something in which many others believe. Again, this creates the feedback loop that can lead to speculative bubbles.