June 29, 2007

How to Spot an Investment Bubble

I came across this article and thought it is a good one.

There were three groups of investors in a room — company executives, graduate-level economists students and econ undergrads. This is an experiment carried out by Researchers Caginalp, Porter and Smith. They showed in a study back in 2000 that stock prices could differ from their fundamental values for long period of time. Much of their study was based on experimental markets — where just about every variable was under their full control. The conclusion was that investor ignorance and ineptitude gives the rest of us some great moneymaking opportunities…

The study, as described in James Montier’s Behavorial Finance, included two-hour “trading sessions” in which each participant was given play money to invest in fictitious stocks. The trading session was divided into 15 separate periods where simulated buying and selling could take place. The players were told that one of the stocks would pay a dividend. They were given a table of what it would likely payout, and they were told that the stock would be worthless at the end of the game:

25% chance of receiving 0 dividend
25% chance of receiving 0.08 dividend
25% chance of receiving 0.28 dividend
25% chance of receiving 0.60 dividend

Expected payout = (0.25x0.0)+(0.25x0.08)+(0.25x0.28)+(0.25x0.60)= $0.24

Given the data, one can determine that the stock would likely pay $0.24 per each share held for each of the 15 periods it was owned in the game. If you multiply them together and the stock is at worth about $3.60 per share, and would be worth $0.24 less as each of the 15 periods gone by. There is no need to concern with present values.

The post-grad economists were the most rational of the 3 group of investors. They got it right. They were willing to pay $3.60 a share and valued the stock $0.24 less each period. The other groups’ behavior, however, if not as ratinal.

The undergrads traded in such a way as to create a price bubble. They were not willing to pay full value for the shares — that is, $3.60 — in the beginning of the game. But then in the middle of the action they bid the stock up 270% more than its fundamental value.

The company execs reportedly were even less rational. They started their bids a little closer to the true fundamental value of $3.60, then bid shares up 530% past it!

We have to bare in mind these were experimental market conditions where you could buy and sell without real world concerns. There were no commissions, liquidity problems, or anything else to worry about. If you wanted to buy the shares, you can buy it at the price you want. There was no trickery here.

The experiment showed that stock market bubbles can occur when you have more neophyte investors involved than rational, educated participants.

Many sets of experiments conducted by Caginalp, Porter and Smith under a host of different conditions have shown that security prices typically start lower than the $3.60 fundamental value during the first period, then rise dramatically higher than the fundamental value during the middle to late periods. Sometime late in the game the asset prices begin to fall hard. They usually fall below their fundamental value.

Follow up studies have shown that market bubbles dissipate over time and the main reason is due to one thing: experience. The groups who ignorantly inflated the price they’d pay for shares learned quicly what not to do in their second and third go-rounds. In fact, in the third round each group played, the bubbles were gone completely.

Apply this to something like the U.S. real estate bubble of recent years. There were a lot of inexperienced people wielding a lot of cheap credit buying up real estate assets at sky-high prices. Many made outrageous claims like “prices would never come down again.”

Many of us knew then, as well as now, that such sentiment was illogical. So, where is the bubble today? Could it be China, whereby newbbies start to bid up the share price way, way above their fundamental value? Can it be Singapore whereby the property prices just shoot through the roof?

As Marc Faber puts it, nowadays, everybody is bullish about something, the equity trader is bullish about equity, the bond salesman is bullish about bonds, the art dealer is bullish about art piece, and the wine dealer is bullish about wine!

When the bubble burst, they will be many people that will get burned, but as for now, the party is still on....

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