Explaining the Bubble

Asset price bubbles have cropped up in financial markets for centuries. Although news accounts talk about price increases and crashes, most of us have little information on the true nature of bubbles and what leads to their formation. Princeton economist Jose A. Scheinkman has studied them carefully, and offered his observations on the topic at the final Friedman Forum Undergraduate Lecture for the year.

“Bubbles are certainly a price phenomenon, but if you just think about prices as being too high or too low you are never going to advance much on the topic,” Scheinkman noted. “It is better to consider, ‘what is the mechanism that generates bubbles beyond just prices?’”

Asset bubbles are short periods when asset prices seem to vastly exceed fundamental of the market. Unfortunately, economists have come to no consensus as to their causes. To make his case for their origins, Scheinkman set forth three facts generalized from his observations of various bubble episodes: first, asset price bubbles coincide with increases in trading volume; second, asset price bubble implosions (or the end of a bubble) coincide with increases in asset supply; finally, asset price bubbles coincide with financial or technological innovations.

Scheinkman illustrated these facts with examples of their role in historical bubbles. In the roaring ’20s, the stock market began to see a lot of overtrading in the years leading up to the crash. For instance, increased trading led to annual turnover of shares on the New York Stock Exchange of 100% from 1925 to 1927 (about what we have today) to more than 140 percent from 1928 to 1929, an astounding increase. “There were 13 records set for number of shares traded between 1928 and 1929.  Another record was not set again until April 1, 1968 when Lyndon Johnson announced that he would not be running for reelection,” Scheinkman pointed out.

The dot-com bust at the beginning of this century perfectly demonstrates that bubbles pop when there is an increase in asset supply. “Lots of companies were changing their names to add ‘.com,’ which would cause their stock prices to go up; we have evidence of that,” Sheinkman explained. “And, of course, there were a lot of small, new companies in the field that were also selling stock.” When enough new companies crowded into the market to satisfy demand, “the [stock price] implosion was caused by an increase in the asset supply.”

History also shows that bubbles form around sectors that produce new technologies. Innovations in every industry from railroads to radios to biotechnology have brought new companies that issue stock, which in turn is gobbled up by investors, just as happened with Internet stocks in the 1990s. Eventually, too much stock is issued and too many companies are created, an oversupply that leads to the inevitable crash in demand.

While the dot-com bubble and its demise brought some significant economic repercussions, some good also came from it as well.

“The new technology companies got capital cheaply, and that means we have growth and technological progress we perhaps would not have had if these companies did not have access to that capital. So, for example, we wouldn’t have Google. We not only have powerful search technology every company benefits from, but we also have innovations in algorithms that post-bubble companies use.”

To explain the mechanism that actually forms the bubbles, Scheinkman presented his model, in which investors are divided into two groups. Group A is rational and makes decisions about investing based on their reading of the markets and the opinions of their friends, while group B makes their decisions based on the opinions of a TV business commentator. “On both sides, there are investors who overestimate their knowledge and therefore make decisions based on that overconfidence,” he added.

According to the model, investors are willing to pay more for a stock than it is currently worth according to its fundamentals because they believe that they will be able to sell it for a profit in the future. As the group who listens to the TV commentator comes to believe that the stock is worth an increasing amount, they are happy to pay more for the stock and to hold onto it. At the same time, the rational group is also willing to pay more on the belief that they will be able to sell their stocks to the other group.

However, once the TV commentator drops his view of the stock, without the rational investors’ knowledge, group B now has the option to sell their stock to investors in Group A. As long as the two groups have different information or beliefs, the option to be able to sell to the other group will always bring a higher price for the stock than its fundamentals indicate. What is more, the more the two groups diverge, the higher prices will rise. “That is the bubble. It is not because one group is more optimistic. The bubble is the value of the option of reselling to the other party in the future,” Scheinkman said.

Once we understand that a higher degree of overconfidence leads to higher prices and higher trading volume, investors should be aware that a certain modesty about their knowledge of a company, market, or sector could help them to make better decisions and avoid creating unnecessary bubbles. But they should also be aware that some asset bubbles, such as those that arise from new technologies, can bring benefits to the wider economy and to society as well.

“This is not true for credit bubbles; they destroy financial systems and really should be avoided,” Sheinkman observed.

— Robin Mordfin