Econ 690 Final Assignment: Is there an Asset Bubble? Senior Seminar Dr. King An asset bubble occurs when a particular asset (e.g., real estate, internet stocks, gold, tulip bulbs) are grossly overvalued to the point where the bubble may burst and prices fall. Most observers believe that internet stocks in 2000 were in a bubble (which crashed), that Japanese real estate represented a bubble in the early 1990s and that gold in the late 70s was in a bubble. Some commentators today believe many assets are in a bubble again. You should complete the assignment in groups of two or three; tell me who did what (and if three people complete the assignment I expect a bit more). 1. Do some basic reading on financial markets. One good place to start is Robert Shiller’s Irrational Exuberance: http://www.amazon.com/exec/obidos/ASIN/0767907183/qid=1091893995/sr=2- 1/ref=sr_2_1/002-3708082-2836034. 2. Please look at the following, as well as your own research: http://www.economics.pomona.edu/GarySmith/BrookingsHousingBubble.pdf#sea rch=%22housing%20bubble%20pomona%22 http://www.cepr.net/publications/housing_fact_2005_07.pdf http://www.ny.frb.org/research/epr/04v10n3/0412mcca.pdf http://www.economist.com/printedition/displayStory.cfm?Story_ID=4079027

3. Choose one particular asset to analyze. It can be local (e.g., real estate in San Francisco), national (e.g., the US stock market) or from another country (e.g., British real estate). For a bubble to occur, an asset must be overvalued by some measure. Choose three measures of valuation for your market. For example, stocks are often measured in terms of earning (P/E ratios) or peak earnings, sales, or replacement value (book value or Tobin’s Q). Real estate is often valued by looking at mortgage payments as a percentage of income, or compared to rentals, or the return someone would get renting real estate compared to alternative returns. 4. Look at the value of you asset over a 15-30 year period (or longer if you can) in relation to the valuation metrics you have constructed. Determine what you think is “fair” value. Is your asset overvalued? Do you think it is in a bubble? What is likely to happen next. (Hint, asset bubbles correct differently, in particular real estate and stock react differently.) 5. Write up your results and submit them to me at [email protected]. Be sure to include data and graphs from (5) above. Please tell me who did what.