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Market Efficiency and Bubbles Economics 71a: Spring 2007 Lecture notes 4.9 Malkiel: 6-8, 11.

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Presentation on theme: "Market Efficiency and Bubbles Economics 71a: Spring 2007 Lecture notes 4.9 Malkiel: 6-8, 11."— Presentation transcript:

1 Market Efficiency and Bubbles Economics 71a: Spring 2007 Lecture notes 4.9 Malkiel: 6-8, 11

2 Outline  Bubbles  Market efficiency  Final advice

3 Bubbles (some examples)  Tulips  South Sea  US Stocks 29  US Stocks 60’s  Japan (80’s)  Internet (90’s)

4 Tulips  Holland  Tulips infected with virus  Causes spectacular colors in infected tulips  These are relatively rare

5 Prices  Tulip prices soar  Everyone gets interested in the tulip craze  Half pound of Witte Croonen went from 64 guilders 1/2 lb to 1668 from Jan to Feb 5th 1637  Back to 37 in 1642  One Semper Augustus goes for $50,000 worth of gold

6 The end: 1637  Bulb prices collapse  Holland goes into a recession  Was it a bubble, compare to today? Mass hysteria Prices moving for no apparent reason

7 South Sea Bubble  England early 1700’s  South Sea company given trade monopoly rights  Company issues stock, but it is not able to make money  Meanwhile in France Mississippi company starts Large conglomerate  South Sea stock takes off

8 The end of South Sea  August 1720  Directors of South Sea Sell  Panic  Government forbids stock certificates until 1825

9 Fun Quote: Sir Isaac Newton  Newton was one of the losers in the South Sea Bubble  “I have learned to predict the movement of celestial bodies but not the movement of man in markets.”

10 3. The Crash of 29  March 1928-Sept 1929 Market increase equals  Everyone gets involved

11 Two features  Margin purchases Buying on credit  Investment Pools Build group Trade stock amongst selves Release good rumors about the stock Start a stampede, then get out

12 The Peak  September 3, 1929 Prices would not be this high for 25 years  Economic activity slowing Fed had been contracting the money supply since 1928 Trying to pop the bubble

13 Most Famous Quote  In Sept. 1929, Irving Fisher of Yale, (inventor of intrinsic value, what we’ve just been doing) “stocks have reached what looks like a permanently high plateau”  Comments on new “economy” Electricity Prohibition

14 Big trouble begins  Monday, October 21st Market falling Volume huge Tickers running behind trades  October 28, 1929 Fall of 15%  October 29, 1929 Fall of 12%  About 40 points, and 30 points

15 Crash of 29 and After Note where the big drops occur

16 Crash of 1987  October 19, 1987  Features Largest one day point drop 508 points % change = 22.6  Huge volume, system overloads  Portfolio insurance

17 Federal Reserve Behavior During the 1987 Crash  Definition: Systemic Risk Financial meltdown Chain reaction  Borrowers default  These defaults cause another set of borrowers to default  …..  Financial system “melts down”  Federal Reserve concerned about this

18 Fed Behavior During the 1987 Crash  With large fall in prices many in trouble  Fed opens short term credit lines  Lender of last resort  After crisis monetary policy tightens  Modern connections: Long Term Capital Management Asian crises Sept 11th

19 Years around 1987: Dow Level

20 Japan: 1990’s

21 Japan Land Bubble  Land goes up 75 times  1990 Japan land 5 times the value of all U.S. land  Value of Imperial Palace = California  Firms use land holdings as collateral  “Japan is different”

22 Comparing 30’s, 87, Japan, and 2002  : Total drop 77%  Japan: Total drop 63% Plus land  1987: Drop = 20% Erased in 2-3 years  2002: Drop off peak S&P 500: 50% NASDAQ: 80%

23 Internet Bubble (90’s)

24 S&P500 versus NASDAQ

25 Yahoo

26 Ebay

27 Amazon

28 Amazon versus NASDAQ

29 Amazon versus P/E Ratio

30 Google versus P/E Ratio

31 Odd Pricing  Market value of Amazon greater than all publicly owned bookstores  Priceline.com market value greater than Delta, United, and American combined

32 AOL/Time Warner  Unusual merger in 2000 Mostly AOL stock Synergies??? Worlds largest media company  AOL removed from name in 2003

33 Bubble/Hysteria Summary  Markets can go out of control  Be watchful for hysteria and outright fraud  However: Hysteria hard to detect when going on Hard to “swim the other way”  Malkiel Markets still basically efficient

34 Outline  Bubbles  Market efficiency  Final advice

35 Efficient Market Hypothesis  Weak-Form Efficiency Prices reflect all market related information (prices/trading volume)  Semistrong-Form Efficiency Prices reflect all publicly available information (accounting fundamentals)  Strong-Form Efficiency Prices reflect all public and private information

36 An EMH paradox  If we believed that markets were efficient, then we wouldn’t waste any time looking for predictability  There would be no one around waiting to eliminate predictability that might occur

37 However,  A key feature of almost all financial markets is that they are rather difficult to predict!

38 Efficient Markets (Defined Again)  Risk/Return Fair world  Information Prices reflect all information Markets efficiently aggregate judgements

39 Risk versus Return Efficient Market View: Investment Opportunities Risk Return * * * * * * *

40 Investment Strategies and Market Efficiency  Technical analysis  Fundamental analysis  Implementation Stock selection Market timing  Index funds

41 Efficient Markets Side  Markets not perfect, but  Markets are still pretty hard to forecast  Who are the “smart people” making money off all the inefficiency? Mutual fund evidence (Malkiel)

42 My Thoughts on Market Efficiency  Perfect efficient market world is wrong Pockets of inefficiency  Can you capitalize on them?  Do they affect the economy?

43 Three Perspectives  Individual investor Should you try to beat the market?  Professional investor Are there places where the full time professional can add value?  Policy makers Do market excesses disrupt other parts of the economy?  Internet bubble  Real estate in 2007


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