CRISIL Young Thought Leader 2009

on

Dealing with asset bubbles

By
Mr. GOUTAM DASH
Master in Business Administration (IB), Second Year
GITAM INSTITUTE of INTERNATIONAL BUSINESS

GITAM INSTITUTE of INTERNATIONAL BUSINESS,

Rushikonda , VISAKHAPATNAM,
A.P., India 530 045.
 TABLE Of CONTENT

2
EXECUTIVE SUMMARY 3
INTRODUCTION 4
HOW IT STARTS? 5
HOW MARKET SHOULD BEHAVE? 5
THE FASCINATING HISTORY OF ASSET BUBBLES:- 6
WHAT CAUSES BUBBLES TO BURST? 8
SUGGESTION 10
BIBLIOGRAPHY 11
 3

EXECUTIVE SUMMARY
Have you heard of the saying “Do not put your eggs in one basket”, especially during the
stock market debates?? Sure you must have. And now we will utilise it for our topic, the
Asset Price Bubble. There have been so many investors-stakeholders who have come up
with various theories on diversification of a portfolio- advised by various broking and
advisory and consultancy firms on not to invest in a single stock or commodity. There is no
second doubt that today people believe and practise diversification, then, the question is
Why did the markets doom? Why was the whole world trapped in a liquidity crisis? Every
downfall in the market leads us new theories, new studies. It is of pertinent nature to get
back to the basics and find out where we went wrong. Let us study the major reasons
behind the abysmal state of the markets.
 If history repeats itself, and the unexpected always happens, how incapable must Man be
of learning from experience? George Bernard Shaw

It is rightly said “Do not put all your eggs in one basket”. This is very much true in the
case of Asset Price Bubble. Many investors come up with so many theories to diversify the
portfolio in better ways, but still the boom happens and all the countries are wrapped in the
liquidity trap. So it is better to know why bubble occurs and what the major reasons are
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therefore.

Financial asset bubbles are the most recurring in any financial crisis that the developing
and the developed nations face. Right from the 17th century Tulip Bubble, the dotcom
bubble in Year 2000 and the recent sub-prime crisis, from which the world has still not
recovered, and each bubble burst shook the world every time as it wiped off with it
thousands of crores of money. It is very
difficult to follow a simple model or a strategy
to control market crashes. An economic model We have seen a significance
differs from human psychology and it is really improvement in the financial model
for investment right from Harry
true. We have seen a significance Markowitz with the mean-variance
improvement in the financial model for portfolio theory; the most used Capital
Asset Pricing Model of Sharpe, Ross‟s
investment right from Harry Markowitz with Arbitrage Pricing Theory and Black &
the mean-variance portfolio theory; the most Schole‟s option pricing and hedging
theory.
used Capital Asset Pricing Model of Sharpe,
Ross‟s Arbitrage Pricing Theory and Black &
Schole‟s option pricing and hedging theory.
But still the stock market crashes.

A bubble is „part of asset price movement that is unexplainable‟ by fundamentals, or

factors that we believe drive the asset price movement. Bubble is the name assigned to
those asset price booms, which are inevitably followed by price tumbling and financial
instabilities/crises. It has been applied to different matters, consciously or unconsciously.
The misapplications are in two directions: 1) The term is often applied to all cases of asset
price boom, with no serious attention paid to whether they are followed by price tumbling
and financial instabilities/crises; 2) It is taken for granted that bubbles are the deviation of
market prices of assets from their true values.
HOW IT STARTS?

The bubble‟s journey comprises a smooth beginning with increasing demand (or
production and sales for a particular commodity) in an otherwise relatively optimistic
market. The attraction to stocks/scripts with good potential gains leads to increase in
investments, possible with leverage coming from novel sources, often from international
investors. This leads to price appreciation. This in turns attracts less sophisticated investors
5
and, in addition, leveraging is further developed with small down payment (small
margins), which leads to the demand for stock rising faster than the rate at which real
money put in the market. At this stage, the behaviour of the market becomes weakly
coupled or practically uncoupled from real (industrial and service) production. As the price
increases, the numbers of new investors entering the speculative market decreases and the
market enters a phase of larger nervousness, until a
point when the instability is revealed and the market
collapses.
The anticipation of rising prices
becomes a self-fulfilling
Bubbles may also reflect investors‟ reactions to prophecy, and market participants
factors unrelated to fundamental economic and enjoy profits that may not
necessarily reflect favourable
business conditions. Hypothetically, individual business prospects.
investors may rush into the stock market because
they believe everyone else is making money in the market. In this case, they prefer to buy
stocks immediately rather than miss an excellent buying opportunity. As a result, the
anticipation of rising prices becomes a self-fulfilling prophecy, and market participants
enjoy profits that may not necessarily reflect favourable business prospects.

HOW MARKET SHOULD BEHAVE?

There is also a debate on this i.e. how market should behave. Should it behave closely to
the fundamental values or whether market psychology and irrelevant factors can cause
prices to deviate substantially from assets fundamental value?

The fundamental value of an asset is usually defined as the present value of the expected
payoff from the asset. Market fundamentals, combined with the efficient market theory,
provides a simple tool for interpreting the fluctuations in security prices. According to the
efficient-market hypothesis (EMH) that financial markets are "information efficient", or
that prices of traded assets (e.g., stocks, bonds, or property) already reflect all known
information, and instantly change to reflect new information. Therefore, according to
theory, it is impossible to consistently outperform the market by using any information that
the market already knows, except through luck. Information or news in the EMH is defined
as anything that may affect prices that is unknowable in the present and thus appears
randomly in the future. This hypothesis has been attacked lately by critics, who blame 6
belief in rational markets for much of the current financial crisis. The EMH theory predicts
that the price of the company‟s stock would jump immediately as investors re-evaluate the
security in the light of new information. In long term perspective of the market we can say
that EMH is valid but in the short-run major shifts are caused by market psychology or
even the things which are not directly related to the business prospects or economic
conditions.

THE FASCINATING HISTORY OF ASSET BUBBLES:-

In the history of financial world, risk reward and catastrophe come as an irregular cycle
witnessed by every generation. Greed, hubris and systematic fluctuations have given us the
first aver asset bubble in history i.e. Tulip mania. This is just the beginning to a long
history. The South sea bubble, the land boom in the industrialisation era i.e. 1920, the US
stock market and great depression in 1929, the October 1987 crash for which analysts are
still to find a reason, the dotcom bubble in 2000 and
the subprime crisis of 2007-2008 have been the Greed, hubris and systematic
fluctuations have given us the
addition to recent history.
first aver asset bubble in
history i.e. Tulip mania.
The first known example of speculative bubble is the
famous Tulip Bubble. This is a history record from the 1620 through 1637. The
speculative bubble involved rare, collectible tulips. The tulips make part of the imports of
Holland before the 1600‟s. As time went by rarer and more valuable classes of tulips
emerged and became a desire item of wealthy Dutch people. Price of this product increases
tremendously. Additionally to these phenomena, Dutch speculator invented a new financial
instrument similar to what is known today as an option. The low cost of this instrument
was of great incentive for people from all social classes to give up their jobs and speculate
in tulip bulbs. The Bubble burst the moment people started pledging land and other asset
for credit. Credit had been exhausted and people were unable to find buyers for their more
expensive bulbs making prices go down over 99% from their peak. A century later the
bulbs were virtually worthless.

1929 burst was definitely the largest crash in the US history. After the crash, stocks were
trading 90% below their 1929 highs and there was a tremendous rush by the investors to
liquidate their equity holdings. Federal Reserve encouraged New York banks to provide
7
the liquidity by decreasing the interest rates and allowing them to borrow at discount rates.
After the liquidity problem was solved in 1930, Federal Reserve increased interest rates to
encourage investors to buy government securities. Market took this action to be speculative
and the economic activity and stock prices kept declining leading to a recession. Although,
Federal Reserve was successful in the immediate actions it took right after the bubble, it
was criticized about the post 1930 policy. After the stock prices crashed in August 1929,
production fell by 50% and the overall price level declined by 30% until March 1933. It is
still argued that the Great Depression should not be attributed to the bursting of the stock
bubble.

After that the major crash took place in October14 1987. The reason for 1987 stock market
crash is yet to be discovered but the major reasons are
computer trading, derivative securities, illiquidity, trade One of the main components
and budget deficits and overvaluation. Then the next of Internet bubbles is
“GetRichQuick” mentality
one is in the year 2000 i.e. DOTCOM bubble. One of
that prevailed in the market.
the main components of Internet bubbles is
“GetRichQuick” mentality that prevailed in the market. Many Venture Capitalists (VCs)
go for finding a dot-com business, taking them to the public and selling the stocks to
realize quick gains. Because of their desire to make quick money, the VCs often bring
premature companies to public, making investors betting on companies that may lack a
good business model. This “GetRichQuick” mentality is also apparent in many investors
who often ignore the fundamental values such as the long-term potential of a company and
its past performance. A lack of solid business model also attributes to the formation of
internet bubbles. Almost every dot-com company, when it goes public, has little earnings
and no major revenue stream with certainly no profits. In addition, many of them are
driven by ideas unlike traditional companies with factories that produce products to sell.
Eager to go for IPO to generate cash that they can invest in building their companies, they
often exaggerate their future potential and give over promises to investors. However, in
the mean time, many of them invest too much money in not-so-important things, because
of their misjudgement in investing money, these companies burn through their cash too
quickly.

Investment bankers play a big part in the creation of internet bubbles. Investment banks
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are free to sell shares that they underwrite on the first day of IPO while a firm needs to
hold its shares for at least six months after the public offering. Because of this, investment
banks can make huge profits by buying shares from the firm at the offering price and
reselling them to the first day purchasers at the market price. Thus, bankers frequently
push entrepreneurs into thinking that business founders have something more than they do.
It leaves a scar on an investment bank‟s reputation if too many companies they bring to
public die, but they have ways to get away with this. First, the trend these days changed so
that companies are going public after just months of operations with no clear plan for
profitability along with losses as opposed to five years of operations
required before going public in the past. Second, with the
The bubbles as “a
significant support from the media, the banks refer the
mysterious storm”
bubbles as “a mysterious storm” that could not have been that could not have
predicted by anybody. This greedy action by investment been predicted by
anybody.
bankers expose premature companies that are not capable of
meeting the expectations of investors, eventually leading to the
bursting of the bubble in the end. And finally sub-prime crisis.

WHAT CAUSES BUBBLES TO BURST?

Financial bubbles can be defined as sharp increases in asset prices that create expectations
of future increases in those prices. These highly overstated expectations cause investors to
speculate over the potential future earnings of the investment in the assets at hand, creating
such phenomena as the famous speculative manias that have been observed at various
times in the past and will most likely continue to pose a threat to future investors. It is a
well known fact that, in cases of mass speculative crazes, the markets cannot sustain the
high prices indefinitely and, eventually, the bubbles burst causing severe damage to the
market and individual investors. The bubbles may be rational, intrinsic and contagious.
Puzzlingly, bubbles occur even in highly predictable experimental markets, where
uncertainty is eliminated and market participants should be able to calculate the intrinsic
value of the assets simply by examining the expected stream of dividends. Nevertheless,
bubbles have been observed repeatedly in experimental markets. Experimental bubbles
have proven robust to a variety of conditions, including short-selling, margin buying, and
insider trading. It is not clear what causes bubbles; there is evidence to suggest that they
are not caused by bounded rationality or assumptions about the irrationality of others, as 9
assumed by “greater fool theory”.

One possible cause of bubbles is excessive monetary liquidity in the financial system,
inducing lax or inappropriate lending standards by the banks, which asset markets are then
caused to be vulnerable to volatile of those asset forces caused by short-term, leveraged
speculation. When interest rates are going down, investors tend to avoid putting their
money into savings accounts. Instead, investors tend to leverage their capital by borrowing
from banks and invest the leveraged capital in financial assets such as equities and real
estate. Economic bubbles often occur when too much money is chasing too few assets,
causing both good assets and bad assets to appreciate excessively beyond their
fundamentals to unsustainable levels.

“Greater fool theory” portrays bubbles as driven by the behaviour of incorrigibly optimistic
market participants (the fools) who buy overvalued assets in anticipation of selling those to
other speculators (the greater fools) at much higher prices. According to this unsupported
explanation, the bubbles continue as long as the fools can find greater fools to pay up for
the overvalued asset. The bubbles will end only when the greater fool becomes the greatest
fool who pays the top price for the overvalued asset and can no longer find another buyer
to pay for it at a higher price.

Extrapolation is projecting historical data into the future on the same basis; if prices have
risen at a certain rate in the past, they will continue to rise at that rate forever. The
argument is that investors tend to extrapolate past extraordinary returns on investment of
certain assets into the future, causing them to overbid those risky assets in order to attempt
to continue to capture those same rates of return. Overbidding on certain assets will at
some point result in uneconomic rates of return for investors; only then the asset price
deflation will begin. When investors feel that they are no longer well compensated for
holding those risky assets, they will start to demand higher rates of return on their
investments.

Another related explanation used in behavioural finance lies in herd behaviour, the fact that
investors tend to buy or sell in the direction of the market trend.

Moral hazard is the prospect that a party insulated from risk may behave differently from
the way it would behave if it were fully exposed to the risk. A person's belief that they are 10
responsible for the consequences of their own actions is an essential aspect of rational
behaviour. An investor must balance the possibility of making a return on their investment
with the risk of making a loss - the risk-return relationship.

SUGGESTION:-

LIFE STYLE WRAP should be the fundamental principle for an investor to invest i.e. life
protection, capital protection and to have a quantitative look towards growth. That is we
can say inflation protection. It is apparent that most bubbles tend to follow discoveries,
technical breakthroughs, or new consumption groups. Historically, the railroad,
automobile, biotechnology, PC, and the Internet boom-and-busts are all examples of
bubbles. Even the Dutch Tulip bubble is a result of a new fashion in arraying fresh tulips
at tops of the women‟s gowns. In all the asset bubbles we have seen that it is short term in
nature. So according to me, in today‟s era or we can say in the coming decade, investors
should invest in green fund. Investors should look towards the company who are following
the theory of triple-bottom line. To be very precise, companies who are continuously
striving towards achieving inclusive growth and sustainable development.
 BIBLIOGRAPHY
1. Investments by Zvi Bodie ( Boston University), Alex Kane (Univerity of
California, San Diego) , Alan J. Marcus (Boston College) & Pitabas Mohanty
(XLRI. Jamshedpur)
2. Is Your Bubble About to Burst? By John Tatom Indiana State University - School
of Business(October 2005) NFI Working Paper No. 2005-WP-02 11
3. The Role of the Informational Efficiency in the DotCom Bubble by Wiston Adrián
Risso , Department of Economics, University of Siena
4. http://www.springerlink.com/index/nl473x605h24031k.pdf
5. http://www.econ.utah.edu/~korkut/Asset%20Price%20Bubbles.pdf
6. Bubble Poppers: Monetary Policy and the Myth of „Bubbles‟ in Asset Prices by Dr
Stephen Kirchner
7. http://www.princeton.edu/~hhong/float26.pdf
8. http://papers.ssrn.com/sol3/Delivery.cfm/per_444.pdf?abstractid=1395148&mirid=
1
9. http://dfm.idaho.gov/Publications/EAB/Forecast/2008/January/Article_0108.pdf