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 lots of money, hence increasing their influence on the market and their ability to eliminate mispricings.

By this standard, it would seem that there should be no cases in history where stock prices have raised (or fell) to a point where they can no longer be explained by rational causes, at all times, the prices of stocks should be a fair reflection of its true fundamental value. During the dotcom boom of the late 90s, where prices raised to an unprecedented high in the US stock market , according to efficient market theory, there should have been economic factors which induced these inflated prices, and there should have been true value to back these prices. However, during that time, basic economic indicators did not come close to increasing by as much as shown in the stock market. For example, corporate profits only rose by less than 60%. By these figures, there seems to be little rational as to why stock prices were so high. Indeed, the collapse of the US stock market in the early 00s indicated that stock prices were indeed to high, and the stock market could no longer support itself.

To investigate whether irrational behaviour, to some extent, helped to cause the IT bubble, I will begin by looking at possible rational explanations and whether they alone can explain the dotcom boom and bust. Then, I will see how irrational behaviour could have contributed.

Some Simple Background Facts

The mainstream introduction of the Internet in 1997 can be compared to the introduction of televisions and personal computers in the amount of influence it has over everyday life. Because of the immediate impressions it makes, people pick up very quickly on the huge impact it will have on commerce. As well as a tool to improve productivity of existing conventional companies, the Internet also made possible the existence of what are now large corporations based solely in the World Wide Web. From the mid 90s, shares in such companies became incredibly popular, and helped to hyper-inflate the prices of their shares, and the whole stock market.

With the floatation of each new company, investors saw increases in the price of shares by hundred-folds; the most notable case being Globe.com, who saw an increase from 97 cents to $9 in one day. There are some examples of financial prices that cannot possibly seem to be right. For example, eToys, an Internet firm specialising in toys, had a stock value of $8 billion, which is greater than the $6 billion value of the established Toys R Us. eToys saw sales of $30 millions, while Toys R Us saw sales of $11.2 billion, and eToys made a loss whereas Toys R Us saw a profit of $376 million.

It would be unreasonable to claim, in the light of these facts, that there was not a speculative bubble associated with the Internet boom.

Rational Behaviour and the Dotcom Bubble

It is true that at least many investors, most of the time, chose to invest in Internet companies because given their beliefs, they saw those companies as the ones that will maximise their earnings, through dividends and the final value of the stock. Are there indications that these earnings justified the prices of the stocks?

There were unusually high levels of stock earnings between 1990 and 2000. Real earnings, according to Standard and Poor's Composite Earnings, more than doubled in the five years prior to 1997, a growth rate not seen for nearly 50 years. Another way to view this is to look at the price-earning ratio. This is a good measure of how 'expensive the market is relative