RMIT Classification: Trusted

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Bubbles and other frothy markets
Dr. Tutsi Sakutukwa

RMIT Blockchain Innovation Hub

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Are Investors always rational?

• https://www.morganstanley.com/articles/top-5-investor-
mistakes

• Read the top 5 investor mistakes discussed by Morgan

Stanley

• Do you think investors are always rational?

• Then do you think the financial markets are really

efficient?

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Are Financial Markets really Fama Efficient?

• The theoretical case for the FEMH rests on three arguments

o Investors are rational and price assets rationally.
o To the extent that some investors are not rational, their
trades are random and their effect is cancelled out.
o To the extent that some investors are irrational in similar
ways their impact on prices are eliminated by rational
arbitrageurs.

• The theoretical case is strong and the empirical evidence

favours the FEMH.

• Yet there are a number of anomalies and potential

problems.

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Are Financial Markets really Fama Efficient?

• Behavioral finance
o Widespread evidence of anomalies is
inconsistent with the FEMH
 Invalid Theory?
 Bad models, data mining, and results by chance
(Fama 1998)
o Anomalies as a pre-cursor to behavioral
finance

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Are Financial Markets really Fama Efficient?

• Investor Biases:
o Representativeness
 Judgments based on stereotypes
o Gambler’s Fallacy
 An overemphasis on mean-reverting behaviour
o Overconfidence
o Anchoring
 Tendency to place too much emphasis on
information (even irrelevant information) that we are
exposed to
o Prospect Theory
 Loss averse not risk averse
 Unable to calculate probabilities of extreme events

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Bubbles

• https://www.youtube.com/watch?v=c_f6lecBVa8

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Bubbles

• Bubbles can be defined as ‘high volume trade at prices considered to be

well-above fundamental value’.

• Difficulty is in establishing ‘fundamental value’.

• Famous Bubbles
o South Sea Bubble
o Tulip mania
o 1920s stock market
o Japan
o Dot-coms
o US housing bubble

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Bubbles

• This time it is different!

o Greater fool theory - naïve investors buy over-valued
assets in the hope of on-selling to even greater fools.

o Extrapolation – simply extrapolate past price increases

into the future.

o Herding – conformity of expectations.

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Bubbles - Japan

o Japanese stock prices in the 1980s.

o French and Poterba (1991)

 “Between 1984 and 1989, the Nikkei Index of Japanese
stock prices rose at an average annual rate of 27.5%, and
its price-earnings ratio increased from 37.9 to 70.9. These
dramatic revisions in share prices and price-earnings
ratios led many analysts to conclude that Japanese
stocks were overpriced.”

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Bubbles: Japan

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Bubbles: Dot.Com

• The Tech-Crash
o Also known as the dot.com bubble

o The discovery of gold on the Internet can be dated, with some

precision, to August 1995, when Netscape, the maker of the
Netscape Navigator Web browser, held its IPO. Like the strike
in the Sierra Nevada, the Netscape IPO attracted a host of
prospectors, but they bore little resemblance to the forty-
niners. Instead of illiterate farmers, they were mostly highly
educated professionals, and they came armed, not with picks
and shovels, but with Harvard MBAs and subscriptions to The
Wall Street Journal.
 John Cassidy

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Bubbles: Dot.Com

• During the dotcom bubble, the value of equity markets grew

exponentially, with the technology-dominated Nasdaq index rising from
under 1,000 to more than 5,000 between the years 1995 and 2000.

• The Nasdaq fell from a peak of 5,048.62 on March 10, 2000, to

1,139.90 on Oct 4, 2002, a 76.81% fall.

• Record amounts of capital flowed started flowing into the Nasdaq in

1997. By 1999, 39% of all venture capital investments were going to
internet companies. That year, 295 of the 457 IPOs were related to
internet companies, followed by 91 in the first quarter of 2000 alone.

• The bubble that formed over the next five years was fed by cheap
money, market overconfidence, and pure speculation.

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Bubbles: Dot.Com

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Bubbles: Dot.Com

• Business lessons from the dot-com bubble

 Casey Kelly-Barton, The Motley Fool
o Look back from 2013 to what happened to the POV Magazine
Top 100 stocks from 1999.
o Of 1999's Top 100 sites, 40 are no longer around. Some were
killed by the dot-com crash, others built their businesses on
now-obsolete technology, and many just plugged along until
their creators or audiences lost interest.
 Survivors held onto their money and diversified their
revenue streams.
 Survivors evolved successfully with the environment—or
changed environments.
 A cool idea is not enough.

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Bubbles: The Global Financial Crisis

• The GFC began in mid to late 2007.

o August 7, 2007 Banque Paribus freezes two hedge fund accounts.
o September 6, 2007 Northern Rock bailout.
o March 15, 2008 Bear Sterns Rescue.
o September 7, 2008 US government seizes control of Fannie Mae and
Freddie Mac.
o September 15, 2008 Lehman Brothers files for bankruptcy.
o September 16, 2008 AIG bailout.
o September 21, 2008 TARP proposed.
o September 23, 2008 TARP rejected.
o September 24, 2008 Ben Bernanke appears before Congress; President
Bush on national prime time television.
o October 3, 2008 TARP Legislation passed.
o February 17, 2009 American Recovery and Reinvestment Act passed.

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Warren Buffet explains the GFC

(2008-2009)

https://www.youtube.com/watch?v=k2VSSNECLTQ&feature=emb_logo
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Global Financial Crisis (2008-2009)

• https://www.rba.gov.au/education/resources/explainers/the-global-
financial-crisis.html

Reserve Bank of Australia (RBA) explains main reasons for the GFC

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Bubbles: The Global Financial Crisis

• Causes of the crisis

o Credit Bubble
o Housing Bubble
o Non traditional mortgages.
o Credit ratings and securitization.
o Financial institutions concentrated correlated risk.
o Leverage and liquidity risk.
o Risk of contagion.
o Common shock.
o Financial shock and panic.
o Financial crisis causes economic crisis.

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Bubbles: The Global Financial Crisis

• Credit Bubble
o The credit bubble was an essential cause of the financial
crisis.
o Global capital flows lowered the price of capital in the United
States and much of Europe.
 Over time, investors lowered the return they required for
risky investments.
 Their preferences may have changed, they may have
adopted an irrational bubble mentality, or they may have
mistakenly assumed that the world had become safer.
This inflated prices for risky assets.
o U.S. monetary policy may have contributed to the credit
bubble but did not cause it.

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Bubbles: The Global Financial Crisis

• Housing Bubble
o There was a large and sustained housing bubble in the United
States.
 The bubble was characterized both by national increases
in house prices well above the historical trend and by
more rapid regional boom-and-bust cycles in California,
Nevada, Arizona, and Florida.
o There was also a contemporaneous mortgage bubble, caused
primarily by the broader credit bubble.
o The causes of the housing bubble are still poorly understood.
 Explanations include population growth, land use
restrictions, bubble psychology, and easy financing.

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Bubbles: The Global Financial Crisis

• Turing bad mortgages into toxic financial assets.

o Fannie Mae and Freddie Mac, as well as Countrywide and
other private label competitors, all lowered the credit quality
standards of the mortgages they securitized.
o A mortgage-backed security was therefore “worse” during the
crisis than in preceding years because the underlying
mortgages were generally of poorer quality.
 This turned a bad mortgage into a worse security.
o Mortgage originators took advantage of these lower credit
quality securitization standards and the easy flow of credit to
relax the underwriting discipline in the loans they issued.
 As long as they could resell a mortgage to the secondary
market, they didn’t care about its quality.

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Bubbles: The Global Financial Crisis

• Big bank bets and bank failure

o Many investors made three ‘bad’ assumptions about U.S.
housing prices.
 A low probability that housing prices would decline
significantly;
 Prices were largely uncorrelated across different regions,
so that a local housing bubble bursting in Nevada would
not happen at the same time as one bursting in Florida;
and
 A relatively low level of strategic defaults, in which an
underwater homeowner voluntarily defaults on a non-
recourse mortgage.

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Bubbles: The Global Financial Crisis

• Dissenting Report – Peter Wallison

o In the end, the majority’s report turned out to be a just so story
about the financial crisis, rather than a report on what caused
the financial crisis.
o Government policy lead to risky mortgages
 Affordable housing policies.
 The Community Reinvestment Act.
 HUD Best Practices guidelines.

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Bubbles: Bitcoin (2017-2018)?

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Bubbles: Bitcoin?

• Economists find the definition of a bubble problematic because the

proper identification of a bubble requires some metrics on which
there is little agreement.
o “an upward price movement over an extended range that then
implodes”
 Kindleberger and Aliber (1996)
o “a situation in which news of price increases spurs investor
enthusiasm, which spreads by psychological contagion from
person to person, in the process amplifying stories that might
justify the price increases and bringing in a larger and larger
class of investors … despite doubts about the real value of an
investment”
 Shiller (2000)

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Bubbles: Bitcoin?

• Some economists conceptualize bubbles as situations in which the

price of the asset grows faster than the asset’s fundamental value, a
notion that is similar to Shiller’s characterization.
o The problem with this description is that the fundamental value
of an asset is not easy to measure.

• Any bubble test that depends on some concept of a fundamental

value cannot be used to detect bubbles in bitcoin.

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Bubbles: Bitcoin?

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Bubbles: Bitcoin?

• Price-volume test:
o In a bubble, demand is triggered by price changes alone, or as
the dominant propelling force, which means that if the volume
of trading can be explained in terms of price dynamics then
this can be taken to indicate the presence of a bubble.

• Technical trading test:

o In a bubble, traders do not pay attention to fundamental
values and concentrate on price movements, which means
that in a bubble technical trading dominates fundamental
trading.

• Structural time series decomposition test:

o Possible to calculate whether there is an explosive trend.

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Bubbles: Bitcoin?

• Based on price and volume data up to the end of November 2017,

formal empirical evidence is presented by using procedures that do
not require the estimation of a fundamental value for bitcoin.

• The empirical evidence shows that:

o (i) the volume of trading can be explained predominantly in
terms of price dynamics;
o (ii) trading in bitcoin is based exclusively on technical
considerations pertaining to past price movements, particularly
positive price changes; and
o (iii) the price of bitcoin is an explosive process.

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Bubbles: Bitcoin?

• Conclusion from the paper:

• “On the basis of the evidence presented earlier it is safe to

conclude that the bitcoin was in a bubble up to the end of 2017. It
is also plausible to view the price correction of early 2018 as
representing the bursting of the bubble, rather than a step in the
price discovery path. ”

• “The behaviour of the price of bitcoin up to the end of 2017 is not a

bubble-like—it is a sparkling bubble. The price reversal of early
2018 is no less than the bursting of the bubble. If the price
recovers to the 2017 level, which is unlikely, this would be bitcoin
https://coinmarketcap.com/currencies/bitcoin/
Bubble 2.0.”

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Bitcoin (2021)

Source: https://coinmarketcap.com/currencies/bitcoin/

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