Financial Market Bubbles and Crashes One would think that economists would by now have already developed a solid grip on how financial bubbles form and how to measure and compare them. This is not the case. Despite the thousands of articles in the professional literature and the millions of times that the word “bubble” has been used in the business press, there still does not appear to be a cohesive theory or persuasive empirical approach with which to study bubble and crash conditions. This book presents what is meant to be a plausible and accessible descriptive theory and empirical approach to the analysis of such financial market conditions. It advances this framework through application of standard econometric methods to its central idea, which is that financial bubbles reflect urgent short side – rationed demand. From this basic idea, an elasticity of variance concept is developed. The notion that easy credit provides fuel for bubbles is supported. It is further shown that a behavioral risk premium can probably be measured and related to the standard equity risk–premium models in a way that is consistent with conventional theory. Harold L. Vogel was ranked as top entertainment industry analyst for ten years by Institutional Investor magazine and was the senior entertainment industry analyst at Merrill Lynch for seventeen years. He is a chartered financial analyst (C.F.A.) and served on the New York State Governor’s Motion Picture and Television Advisory Board and as an adjunct professor at Columbia University’s Graduate School of Business. He also taught at the University of Southern California’s MFA (Peter Stark) film program and at the Cass Business School in London. He earned his Ph.D. in economics from the University of London and currently heads an independent investment and consulting firm in New York City. Mr. Vogel is the author of the seven editions of Entertainment Industry Eco- nomics (eighth forthcoming) and Travel Industry Economics, all published by Cambridge University Press. Reprinted with permission from Kevin KAL Kallaugher, www.Kaltoons.com Financial Market Bubbles and Crashes Harold L. Vogel CAMBRIDGE UNIVERSITY PRESS Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, Sao˜ Paulo, Delhi, Dubai, Tokyo Cambridge University Press 32 Avenue of the Americas, New York, NY 10013-2473, USA www.cambridge.org Information on this title: www.cambridge.org/9780521199674 © Harold L. Vogel 2010 This publication is in copyright. Subject to statutory exception and to the provisions of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press. First published 2010 Printed in the United States of America A catalog record for this publication is available from the British Library. Library of Congress Cataloging in Publication data Vogel, Harold L., 1946– Financial market bubbles and crashes / Harold L. Vogel. p. cm. Includes bibliographical references and index. ISBN 978-0-521-19967-4 (hardback) 1. Capital market. 2. Financial crises. 3. Commercial crimes. I. Title. HG4523.V64 2010 338.542–dc22 2009038062 ISBN 978-0-521-19967-4 Hardback Cambridge University Press has no responsibility for the persistence or accuracy of URLs for external or third-party Internet Web sites referred to in this publication and does not guarantee that any content on such Web sites is, or will remain, accurate or appropriate. TO MY DEAR PARENTS – WHO WOULD HAVE GREATLY ENJOYED SEEING THIS Contents Prologue page xiii Preface xvii Part I: Background for analysis 1 Chapter 1 Introduction 3 1.1 Overview 3 1.2 On the nature of humans and bubbles 7 Macro aspects 7 Social and utility theory aspects 11 Psychology and money 13 Equilibrium aspects 14 1.3 Central features 14 1.4 On defining bubbles 15 vii viii Contents Chapter 2 Bubble stories 27 2.1 Tulips 27 2.2 England and France, 1700s 29 South Sea Bubble 29 Mississippi Bubble 30 2.3 The Roaring Twenties 32 2.4 Japan 1989 34 2.5 Tech/Internet Stocks, 1987 and 2000 38 2.6 Housing, credit, and commodities, 2002–8 42 Housing and credit 42 Commodities 46 2.7 Conclusions 48 Chapter 3 Random walks 60 3.1 The efficient market hypothesis 61 3.2 Capital Asset Pricing Models 62 3.3 Volatility aspects 65 Volatility and modern portfolio theory 65 Volatility implications 66 3.4 Conclusions 69 Chapter 4 Bubble theories 77 4.1 Rational expectations 77 4.2 Behavioral features 79 Behavioral finance I 79 Behavioral finance II 81 Herding and anomalies 84 4.3 Asset bubble and crash analyses 86 Rational bubbles and crashes 88 Other studies 91 Testing methods 95 Flow of funds factors 96 Crashes 98 4.4 Power laws and chaos concepts 99 Power laws 99 Chaos concepts 103 4.5 Conclusions 104 Chapter 5 Framework for investigation 120 5.1 What’s a bubble? 121 5.2 Credit, debt, and other commonalities 123 5.3 Entropy and information 127 Contents ix 5.4 Toward a new theory 130 Characterizational issues 130 Geary’s test 131 Length and number of runs 132 Launch zone conditions 133 Peak zone conditions 133 Real runs analysis 134 Transactions volume aspects 139 5.5 Conclusions 140 Part II: Empirical features and results 151 Chapter 6 Bubble basics 153 6.1 Equity risk premiums 154 Overview 154 Estimation problems 154 6.2 Preliminaries 161 Procedural approach 163 Searching for launch zones 165 6.3 Persistence measures 166 6.4 Equilibrium concepts 168 Equilibrium concepts I – quasi-equilibrium 169 Equilibrium concepts II – Walras, Benassy,´ and Malinvaud 170 6.5 Trading volume and variance 172 6.6 Conclusions 173 Chapter 7 Bubble dynamics 183 7.1 Setting up 183 7.2 Path-length, elasticity, and exponentiality 184 Path-lengths 185 Elasticity 187 Absolute quasi-equilibrium 189 Exponentiality 191 Finding bubbles 194 Bubble strength indicator 197 7.3 Reality checks 200 First interpretations 200 Market metrics 201 Coincidental history 202 7.4 Conclusions 205 x Contents Chapter 8 Money and credit features 215 8.1 Historical perspectives 215 Theories 215 Realities 217 8.2 Liquidity issues 218 8.3 Role of central banks 222 8.4 Conclusions 223 Chapter 9 Behavioral risk features 229 9.1 Behavioral risk premium 229 9.2 High anxiety 230 9.3 Crooked smiles 230 9.4 Transactions per unit time 233 9.5 Conclusions 237 Chapter 10 Crashes, panics, and chaos 242 10.1 Crashes and panics 242 Crashes 242 Panics and collapses 243 Business cycle aspects 246 Crash strength indicator 248 An empirical application 250 Liquidity effects 253 10.2 Thresholds and velocities 256 10.3 Chaos concepts applied 257 Overview 257 Lyapunov exponents 258 10.4 Conclusions 259 Chapter 11 Financial asset bubble theory 269 11.1 Research results 272 11.2 Predictability and forecasting 275 Predictability 275 In reality 275 Forecasting 275 11.3 Knowns, unknowns, and conjectures 276 Facts 277 Unknowns 277 Conjectures 277 11.4 Further research directions 278 Contents xi APPENDICES 283 A. Methodological details for finding bubbles 285 B. Observation lookup table 287 C. Damodaran annual statistics 291 Glossary 293 References 301 Index 339 Prologue Bubbles are wonders to behold. They take your breath away and make your pulse race. They make fortunes and – just as fast or faster, in the inevitable stomach-churning crash aftermath – destroy them too. But more broadly, bubbles create important distortions in the wealth (e.g., pensions), psychol- ogy, aspirations, policies, and strategies of society as a whole. Bubbles, in other words, have significant social effects and aftereffects. One would think, given the importance of the subject, that economists would by now have already developed a solid grip on how bubbles form and how to measure and compare them. No way! Despite the thousands of articles in the professional literature and the millions of times that the word “bubble” has been used in the business press, there still does not appear to be a cohesive theory or persuasive empirical approach with which to study bubble and crash conditions. This book, adapted from my recent Ph.D. dissertation at the University of London, presents what is meant to be a plausible and accessible descrip- tive theory and empirical approach to the analysis of such financial market conditions. It surely will not be the last word on the subject of bubble xiii xiv Prologue characteristics and theory, but it is offered as an early step forward in a new direction. Development in this new direction, however, requires an approach that appreciates the thinking behind the standard efficient market, random walk, and Capital Asset Pricing Models, but that also recognizes the total useless- ness of these concepts when describing the extreme behavior seen in the events that are loosely referred to as bubbles or crashes. The body of work that is known as behavioral finance, it seems, ends up being much closer to what is needed. And along these lines, the notion of a behavioral risk premium is introduced. Yet none of this gets to the heart of the matter: When it comes to asset price bubbles and crashes, the most visibly striking and mathematically important feature is their exponentiality – a term that describes the idea that growth accelerates over time. However, although exponentiality is the essence of any and all bubbles, it is merely a manifestation of short-rationed quantities. In plain English, this means that people make trading decisions based mainly on the amount that, for whatever reasons – fundamental, psychological, or emotional – they need to buy or sell now. Considerations of current prices thus begin to take a backseat to considerations of quantities: In bubbles you can never own enough of the relevant asset classes, and in crashes you cannot own too little of them.