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Financial Market Bubbles and Crashes, Second Edition Harold L Financial Market Bubbles and Crashes, Second Edition Harold L. Vogel Financial Market Bubbles and Crashes, Second Edition Features, Causes, and Effects Harold L. Vogel New York, NY, USA ISBN 978-3-319-71527-8 ISBN 978-3-319-71528-5 (eBook) https://doi.org/10.1007/978-3-319-71528-5 Library of Congress Control Number: 2018935300 © The Editor(s) (if applicable) and The Author(s) 2018 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprint- ing, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, com- puter software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors, and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, express or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. Cover image © Anna Nikonorova / Alamy Stock Photo Cover design by Jenny Vong Printed on acid-free paper This Palgrave Macmillan imprint is published by the registered company Springer Nature Switzerland AG The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland To my dear parents, who would have greatly enjoyed seeing this. Reprinted with permission from Kevin KAL Kallaugher, www.Kaltoons.com 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, bub- bles create important distortions in the wealth (e.g., pensions), psychology, aspirations, policies, and strategies of the 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 Ph.D. dissertation at the University of London, presents what is meant to be a plausible and accessible descriptive 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 characteristics and theory, but it is offered as an early step forward in a new direction. Development in this new direction 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 uselessness of these concepts when describing the extreme behavior seen in the events that are loosely referred to as bubbles or crashes. What is known as behavioral finance, extended here via the notion of a behavioral risk premium, ends up being much more pragmatic. 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 starting even at relatively slow rates of growth, price changes in each period must soon, by dint of the underlying arithmetic, become astonishingly large. Exponentials appear when the rate at which a quantity changes is proportional to the size of the quantity itself. ix x Prologue Although exponentiality is the essence of any and all bubbles, it is merely a manifestation of short-rationed quantities (not to be confused with the practice of short-selling). In plain English, this means that people make trading deci- sions 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. The problem, though, is that this rubs against the neoclassical economist’s empirically unproven approach in which the participant is presumed to be a “rational” calculating automaton tuned into a world with perfect, symmetri- cally available, instantly digested and analyzable information that causes the market to quickly arrive at “equilibrium.” However, this will never happen because, if it did, the market would cease to exist; it would disappear as there would be no further need for it. In extreme market events, as ever more investors stop denying and fighting the tide and join the herd, the rising urgency to adjust quantities is reflected by visible acceleration of trading volume and price changes noticeably biased, to one side or the other. And this is where the magical constant e, which approxi- mately equals 2.718, enters as a way to describe the exponential price-change trajectory that is so distinguishable of bubbles (and crashes). What a number this e is. It suggests steady growth upon growth, which leads to acceleration. Keep the pedal to the metal in your car or rocket ship and you go faster and faster with each additional moment of elapsed time. It is the mechanism of compound interest. In calculus, it is its own derivative—no other function has this characteristic. Best of all, even a non-mathematician such as I can figure it out using only basic arithmetic. A brief example suffices to demonstrate the power of compounding (i.e., geometric progression). I sometimes ask MBA students in finance whom I occasionally have the privilege of addressing: “Quick, if I give you one penny today and steadily double the resulting amount every day for the next 30 days after, what will the total then be?” Remember, we’re talking here about only one single penny, one measly little hundredth of a dollar and only a month’s time. Most guesses of even these bright students are, as most of ours would be, far off the mark. The answer is $10,737,418. That’s—starting from a penny— nearly $11 million in a month! It is the ultimate bubble. More specifically, though, all such compounding begins unimpressively with a largely unremarkable buildup so that on the 8th day of doubling the total is only $2.56, a sum barely sufficient to buy a decent cup of coffee. Yet flash for- ward to the 29th next-to-last day and the total has reached $5.369 million, which means that valuation rises by $5.369 million in the single last day. Given that bubbles and crashes exemplify such exponential-like price-change patterns (e.g., see Figs. 8.6 to 8.8), it should thus not be surprising that the largest magnitude changes per unit time—market “melt-ups” and “crash-downs”— typically occur in the crescendo of buying in approach to the top and the capitulative selling in approach to the bottom. Short-rationing behavior is most evident and intense during such times. Prologue xi This work should first of all be of interest to financial economists of all stripes and to general readers interested in markets and finance. Yet the poten- tial audience ought to extend also to MBA- and Ph.D.-level students, central bank policy makers and researchers, commercial and investment bankers, inves- tors and speculators, and technical and fundamental market analysts. In this pursuit I have aimed for comprehensibility and comprehensiveness to appeal to and accommodate both generalist and academic readers. To this end, the text is structured so that the first four chapters at most require for assimilation only a background that might include college-level finance and economics courses. A brief glossary of terms and acronyms has also been appended as a conve- nience for general readers. Meanwhile, the deeper academic material that might be primarily of interest to serious researchers and financial specialists appears in Part II, where the goal is not to provide extensive coverage of theories that have been around a long time but to instead provide contextual and historical perspectives in support of the new approach that is presented in Part III. This structure allows modules to be readily tailored to different audiences. This second edition, shaped by the bubble and crash events of the eight intervening years since the first edition, has been enlarged, updated, and reor- ganized. There are new sections on the global central bank-induced yield-chas- ing bubble that occurred between 2009 and 2017, on the important relationship between trust and credit, on quantitative easing and other unconventional cen- tral bank policies that have been experimentally implemented, on the develop- ment of volatility metrics and crash intensity measures, and on the more recent math-imbued stochastic dynamic approaches to modeling bubbles and crashes. This project would have never been completed without the many great works that came before and the many kind people who provided encourage- ment, help, and good cheer during its production.
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