Lecture 23: Stock Market Booms and CrashesBrief History of Booms and CrashesUp-CrashesMackay vs. GarberEfficient Markets HypothesisIrrational ExuberanceThe Stock Market in Historical PerspectiveS&P500 Jan 1871-Feb 2004S&P 500 Price/(10-Year Earnings) Jan 1881-Feb 2004Nikkei Index, Jan 1984-Feb 2004Germany Dax Nov. 1990 – Nov. 2003UK FTSE 100 April 1984-Nov. 2003France CAC 40 March 1990- Nov. 2003P/E Predicts 10-Year ReturnsOne-Year Confidence, USAValuation Confidence, USAFaith in the Stock MarketHistorical Intervals between Normal Years (Excluding War, Recession)Earnings, Productivity & ValuePart 1: Structural FactorsPrecipitating FactorsVariations in Factors Since March 2000Amplification MechanismsAmplification Through ExpectationsPart 2: Cultural FactorsLargest Recent One-Year Real Stock Price ChangesPart 3: Psychological FactorsProminent Psychological TheoriesPart 4: Attempts to Rationalize ExuberancePrice and Dividend Present ValueIrving Fisher 1929The Crash of 1929The Crash of 1987Questionnaire Survey Oct 1987Ranking of Importance of News StoriesPsychology or Fundamentals?1987: Investors Thought They Knew What Will HappenThe Nikkei Crash after 1989Samuelson’s DictumPresent Value of Dividend Changes Plotted Against D/P RatioPart 5: Tension Between Efficient Markets Theory and Behavioral FinanceConcluding ThoughtsSlide 43Slide 44The Next Few DecadesDramatic Change in Finance, our EconomyRisk and Chance over CareersEcclesiastes IX 11Career RisksA Risky WorldHuman Capital, Positioning, and MeaningDon’t Sell your TextbookLecture 23: Stock Market Booms and CrashesBrief 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 SeasUp-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 downcrashMackay 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 rationalityEfficient 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 marketsIrrational 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 DecadesThe Stock Market in Historical PerspectiveS&P500 Jan 1871-Feb 2004S&P 500 Price/(10-Year Earnings)Jan 1881-Feb 2004Nikkei Index, Jan 1984-Feb 2004Germany Dax Nov. 1990 – Nov. 2003UK FTSE 100 April 1984-Nov. 2003France CAC 40March 1990- Nov. 2003P/E Predicts 10-Year ReturnsPrice Earnings Ratio Predicting Subsequent Ten-Year Real ReturnsAnnual January Data, 1881-1990 (1891-2000 returns)-5051015200 5 10 15 20 25 30 35 40 45 50S&P Real Price / 10-Year Average Real EarningsS&P Ten-Year Subsequent Real Return192919901919191418991982196519111935One-Year Confidence, USAValuation Confidence, USAFaith 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 20031. 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. 1988-1996Earnings, Productivity & ValueGrow th over Historical Intervals-10-50510151 2 3 4 5 6 7 8 9Interval NumberGrow th Rate (Annual %)Real S&P EarningsProductivity (Gordon Multifactor)Real Cumulated S&P Value (w ithDividends)Part 1: Structural Factors•Precipitating Factors: the Internet, the Baby Boom, and other events•Amplification Mechanisms: Naturally Occurring Ponzi SchemesPrecipitating 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 OpportunitiesVariations 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 SchemeAmplification 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