Transcript Lecture16 : Bubbles and Busts in the 20th Century

Bubbles and Busts:
From the 1920s to the 1990s
1999!
“History is continually repudiated.”
--Glassman and Hassett
The Dow 36,000 (1999)
•What can we learn from history?
•Booms and busts have common elements
•Evidence weak that booms are solely
fundamentals driven
•Role of Federal Reserve is very limited and
should not be pre-emptive
What’s a Stock Market Boom?
or any “Asset” Market Boom?
• “Booms” are relatively rare long upward
swings that dominate any brief retreat.
• Annual data is the most appropriate
frequency to identify a boom.
• An arbitrary criterion that picks out the
popularly-identified booms: three
consecutive years of returns over 10
percent.
What’s a Stock Market Crash?
• October 1929 and October 1987,
universally agreed to be crashes, are
used as benchmarks. In both cases,
the market fell over 20 percent in one
and two days’ time.
• The fall in the market, or the depth, is
one characteristic of a crash. There
was no sudden decline for the
Dot.Com crash of 2000, even though
we consider it a crash. Thus, speed is
another feature.
• Crashes are identified by (1) Speed (2)
Depth and (3) Duration---it should last
for some time.
Identifying a boom by (about) three years
of annual returns over 10% with a little
generosity
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1921-1928: 20, 26, 2, 23, 19, 13, 32, and 39%.
1942-1945: 11, 18, 15 and 30%.
1949-1956 18, 22, 15, 13, 2, 39, 25%.
1963-1965 17, 13, and 9%.
1982-1986: 22, 14, 4, 19 and 26%.
1995-1999: 27, 21, 22, 25 and 12%.
Crashes: Where the Dow Jones, S&P500
or Nasdaq decline by more than 20%
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•
•
•
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•
•
•
1903
1907
1917
1920
1929
1930-1933
1937
1940
•1946
•1962
•1969-1970
•1973-1974
•1987
•1990
•2000.
Matching booms with crashes: bubbles?
•
•
•
•
•
Booms:
1924-1929
1942-1945
1982-1987
1995-2000
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•
•
•
•
Crashes:
1929/1930-1933
1946
1987
2000
Recovery after 1946 was quick (duration
short) so three stock market bubbles in 20th
century
Do Booms and Busts Share Common Features?
Boom and Bust 1920-1933
120
Peaks = 100
100
80
60
40
20
0
1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933
Dow Jones
Cowles
Equally Weighted
Do Booms and Busts Share Common Features?
Boom and Bust 1980-1990
120
Series Peaks = 100
100
80
60
40
20
0
1980
1982
1984
1986
Dow Jones
S&P500
1988
Nasdaq
1990
Do Booms and Busts Share Common Features?
Boom and Bust 1990-2003
120
Series Peaks = 100
100
80
60
40
20
0
1990 1991 1992 1993 1994 1995 1986 1997 1998 1999 2000 2001 2002 2003
Dow Jones
S&P500
Nasdaq
Table 1: Characteristics of Booms and Busts
Peak
Trough
Drop
Peak to
Trough
(months)
Recovery
to Peak
Date
1920s
Dow Jones
Aug-29
Jun-32
-0.822
34
Nov-54
Cowles
Sep-29
Jun-32
-0.849
33
Nov-53
Equally-Weighted
Feb-29
May-32
-0.896
39
Sep-45
Dow Jones
Aug-87
Nov-87
-0.302
3
Jul-89
S&P 500
Aug-87
Nov-87
-0.311
3
Jul-89
Nasdaq Composite
Aug-87
Dec-87
-0.299
4
Jun-89
Dow Jones
Dec-99
Sep-02
-0.339
34
May 2006
S&P 500
Aug-00
(1485)
Sep-02
-0.463
26
(Apr 07 1424)
Nasdaq Composite
Mar-00
(4802)
Oct-02
-0.741
32
(Nov 09
1072)
1980s
1990s
What causes stock market booms
and abrupt reversals?
• Probabilities of long positive runs are small
– [Madoff set off alarm bells because he had
continuous positive monthly returns for years]
• Probabilities of crashes are small
• Can fundamentals really shift that fast?
• Or is the crowd just mad?
Fundamentalists and Maniacs in the 1920s
• Looking back on the 1920s, Professor John B. Williams of
Harvard (1938) wrote:
“Like a ghost in a haunted house, the notion of a soul
possessing the market and sending it up or down with a
shrewdness uncanny and superhuman, keeps ever
reappearing….Let us define the investment value of a stock
as the present worth of all the dividends to be paid upon it.”
• John Maynard Keynes (1936) chose to differ:
“A conventional valuation which is established as the
outcome of the mass psychology of a large number of
ignorant individuals is liable to change violently as the
result of a sudden fluctuation of opinion which do not
really make much difference to the prospective yield…..the
market will be subject to waves of optimistic and
pessimistic sentiment, which are unreasoning.”
Fundamentalists and Maniacs in the 1990s
• On the threshold of the great bull market, Robert Shiller
(1991) observed:
“I present here evidence that while some of the implications
of the efficient markets hypothesis are substantiated by
data, investor attitudes are of great importance in
determining the course of prices of speculative assets.
Prices change in substantial measure because the investing
public en masse capriciously changes its mind.”
• In contrast, John Cochrane (1991) expounded:
“We can still argue over what name to attach to residual
discount-rate movement. Is it variation in real investment
opportunities not captured by current discount model? Or is
it “fads?” I argue that residual discount-rate variation is
small (in a precise sense), and tantalizingly suggestive of
economic explanation. I argue that “fads are just a catchy
name for the residual.”
Fundamentals
•Fundamentals require that stock prices equal the present discounted
value of expected future dividends.
•P = Dt+1/(1+r)1 + Dt+2/(1+r)2 + Dt+3/(1+r)3 +……..
•If all dividends are equal and certain then
•P = D/r
•If all earnings paid out then same as P=E/r or P/E = 1/r, if an
acceptable return is 6% on stocks, then P/E is 16.7
•If allow for some growth--the Gordon growth model—where D
grows at a constant rate g and investors command a constant return
of r, composed of a risk free rate and an equity premium.
• P = (1+g)D/(r-g)
Has almost all elements any analyst uses today!!!
Prices rise because dividends are growing, the risk free rate is down
or the equity premium has fallen…
The Gordon model captures all
explanations for asset price movements,
including booms and busts:
(a) *Technological
change
increasing
productivity and leading to higher
dividend growth
(b) Changes in the risk free rate
(c) *Changes in the equity premium
Frustrating!
•Explaining actual stock price movements with fundamentals
has proved frustratingly difficult.
•If expectations are rational, stock prices should embody the
realized dividends in the future appropriately discounted.
•In a classic article, Shiller (1981) found that stock prices
moved far more than was warranted by the movement in
dividends, where the ex post rational price was equal to the
discounted value of the future stream of realized dividends.
•Even if there were deviations in was expected from what was
realized, the fit should have been good over 1871-1979, yet the
variation of prices exceeded the variation in fundamental prices
violating any reasonable test.
Background of Two Booms
1920s
v.
1990s
• Zero inflation, 4%
unemployment, balanced
budget
• Real Earnings jump
• Real Dividends jump
• Soaring Prices
• Collapse in D/P and E/P
• Low
inflation,
low
unemployment, balanced
budget
• Real Earnings jump
• Real Dividends don’t
• Soaring Prices
• Collapse in D/P and E/P
Explanation: Technological
Change or the “New Economy”
• In the 1920s and 1990s bull markets,
technological innovations were viewed as
improving the marginal product of capital,
increasing earnings and hence dividend
growth.
•A wave of innovations, sometimes
characterized as a new “general purpose
technology” was believed to have placed the
economy on a higher growth path.
The New Economy of the 1920s
• Irving Fisher: the stock market boom
justified by the rise in earnings, driven by
the systematic application of science and
invention in industry and the acceptance of
the new industrial management methods.
• High Tech Industries: Automobiles, Radio,
Aircraft, Movies, Electric Utilities, Finance
• But some executives (A.P. Giannini of Bank
of Italy) feel prices are too high and say
they will not pay higher dividends.
The New Economy of the 1990s
• General purpose technology of 1990s greater
impact than in 1920s—computers, the internet,
biotech!!!
• “Moore’s Law” number of transistors per
integrated circuit doubles every 18 months, helps
drive price declines.
• Estimated average annual price declines for
electricity and automobiles: 2%, but computer
prices collapsed at a rate of 24%.
• Faster rate of change and price decline in the
1990s, promised higher levels of growth and
consumption.
• IS THIS THE EXPLANATION?
Ummmmm…..Productivity Growth
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1870-1891: 0.39%
1890-1913: 1.14%.
1913-1928: 1.42%
1928-1950: 1.90% Golden Age of GP Tech
1950-1964: 1.47%
1964-1972: 0.89%
1972-1979: 0.16%
1979-1988: 0.59%
1988-1996: 0.79%
1995-2000: 1.35% .
1920s and 1990s Fundamentals?
• Apply a Gordon model to S&P500 data and
calculate the growth rates that would be needed to
justify the peak P/D (similar to P/E)
• P = (1+g)D/(r-g),
• For 20th century, average P/D was 28 and real g
was 1.4%, implying an r of 5%.
• To match 1929 high ratio of 38 with r of 5%
would require g of 2.3%. (7% implies g=4.3%)[1]
• To match 1998 high ratio of 48 with r of 5%
would require g of 2.9% (7% implies g=4.8%)
• Huge historical leaps--a doubling of productivity
growth
Explanation 1?
For both the 1920s, the conclusion for
the 1990s is fairly clear: expected
dividend growth was not a major
factor driving the boom. The surge in
earnings was part of a robust business
cycle but did not have a sufficient
permanent component to raise stock
prices
Explanation: Changes in the
Discount Rate
• The return required or stock yield (r) has
become the favored factor behind stock
market booms.
• R = risk free rate and an equity premium. It is
believed to be moved primarily by the latter,
as the risk free rate is held to be relatively
constant.
• The equity premium is then calculated as the
difference between the stock yield and a
measure of the risk free rate.
The Equity Premium
• For 20th century:
stock yield= dividend yield and growth
D/P = 4.5% Real growth = 1.7%
Real 10 year bond yield = 3.2%
Equity premium = 6.2% – 3.2% = 3.0%
Booms: Below 2% 1929, near zero 1990s
But is this warranted, aren’t stocks really
“risky”
Bullish on the Equity Premium
• “A Paradigm Shift” Glassman and Hassett, The
Dow 36,000 (1999) diversified portfolio of stocks no
more risky than U.S. government bonds
• “Stocks should be priced two to four times higher--today. But it is impossible to predict how long it
will take for the market to recognize that Dow
36,000 is perfectly reasonable. It could take ten
years or ten weeks. Our own guess is somewhere
between three and five years, which means that
returns will continue to average about 25% p.a.
• Rationale: premium can fall from 2.8 to 0.8%: real
long term bond rate of 2% and g = 2.3% permits a
D/P of 1.5% to fall to 0.8% with a tripling of P.
• P/D = 41 rising to 127
Bottom Line on Bubbles
• Huge swings in stock markets are
impossible to justify by real factors.
• Dividends, Earnings, Interest Rates and the
Equity Premium don’t move as much as
prices.
• Prices tend to follow these fundamentals but
not always
Is there a bubble out there? How to
measure????
• Evidence in the market for
brokers’ loans that lenders
were very skeptical of the
height that the market had
attained in late 1929.
• Extraordinary interest premia
• Margin demanded rises from
25% to 50% lenders felt they
needed this protection against
a potentially huge decline in
the market.
Costs of a Bubble: Distorted Decisions
• Keynes (1936): “Speculators may do no harm on a
steady stream of enterprise. But the position is
serious when enterprise becomes the bubble on a
whirlpool of speculation. When the capital
development of a country becomes a by-product
of the activities of a casino, the job is likely to be
ill-done.”
• A bubble will (1) raise household wealth causing
higher than optimal consumption, (2) produce
overinvestment it will raise market value to book
value in Tobin’s q, and (3) induce more firms to
borrow because of higher value of collateral and
firms switch to equity finance if there is a lower
equity premium. Crash will create credit crunch.
Should the Fed intervene?
Should it pop a bubble?
What’s the optimal policy
• NO INTERVENTION IN THE BUBBLE:
Powerful traditional lesson---drawn from
experience of 1928-1933---is keep monetary policy
focused on inflation and growth, not the stock
market.
• BUT STEP IN TO PREVENT A PANIC:
Intervention is appropriate for a central bank as
lender of last resort to intervene temporarily in a
payments crisis or financial intermediation crisis
and then withdraw injected liquidity (as in 1929
and 1987).
Remember the Backdrop to the Boom
• 1920s: long post-World War I economic
boom, preceded by high inflation, hard
recession and many bank failures.
• 1922-1929,
GNP
grew
at
4.7%,
unemployment averaged 3.7%. (2 brief
recessions), and no trend inflation
• Fed accommodated seasonal demands for
credit and countercyclical policy, 1914-1929
The Fed and the Boom
• Beginning in 1928, the Fed becomes obsessed
with the rapidly rising stock market. Fears that
there is “non-productive” investment--speculation may lead to inflation.
• In February 1929, Board chairman Young spoke
out against excessive speculation. “Direct
pressure” on member banks to limit "speculative
loans.“ NY Fed opposes and wants to raise rates
• August 1929 when the discount rate raised from
5 to 6%, just as the economy reaches its cyclical
peak.
• Crash October 1929—2 days market falls 20%
Intervention in a Crash?
• NY Fed injects liquidity (easy loans to banks) into
market in response to crash of October 1929
• Stressed brokers and customers need credit as margin
calls are made.
• Danger of collapse of securities firms and clearing
and settlements system.
• Interest rate spreads widen then close as crisis abates.
• FR Board criticizes NY Fed for saving speculators
• Credit tightened again even though country sliding
into recession.
• Continued worry over stock market leads to
excessively tight policy after stock market crash
when still worried about speculative excess.
• Helps to start the Great Depression----lesson learned
in 1987---Fed moves with unanimity to prevent panic
after crash, economy quickly recovers.
Conclusion
• Measures of stock market boom
fundamental and bubble components are
fragile at best.
• Although there may be a bubble in the
market, central banks should not intervene
but focus on inflation and growth
• Central banks proper role is as a lender of
last resort if a stock market crash threatens
the payment system or intermediation.