That is the question!
So the Dow has finally hit 10,000. I know my life (if not my poor, empty,
graduate student wallet) is fundamentally richer for it.
I’ve been waiting for CNBC to give
me a call to ask my opinions on Dow 10,000, but, alas, sitting patiently
by the phone has not paid off. Instead, I thought I would ask myself about
the market and bubbles.
Q: What’s a stock bubble?
A: A bubble is used to describe a stock that is trading at a price above
its fundamental value.
Q: So then, wise guy, what is a stock’s fundamental value?
Typically, the fundamental value of a stock is equal to the present
discounted value of the stream of dividends paid by the stock. Basically,
it’s the amount of money that you can expect to get back from the stock
if you hold it into the distant future – taking into account the fact that
1$ is worth more today than tomorrow. Things like a healthy
economy, growing profit margins, a growing consumer base, etc., lead
to better fundamentals and a higher stock price.
It’s getting harder to sell this story to my students since a growing
number of stocks – especially the new hot internet issues which typical
MIT students follow – do not pay regular (or any) dividends. The best way
to think about the fundamental value of a stock for these cases is to think
of the value of the company as the price it would receive should it be
sold to another company at some point in time – the equivalent of a zero
coupon bond with an uncertain maturity and face value!
Q: So why do prices get above the fundamental value?
A: Well, that’s the hard question. The easy — well, easier — question
to answer is why the price stays above the fundamental value once it’s
there. Below is a simple numerical example of how
a bubble might work.
The basic story is that if there is a bubble that has some chance of
“bursting” – or have its price drop significantly – people will not be
willing to hold the stock unless there is a high rate of return. As the
price rises, the loss of money due to a fall becomes even greater, causing
the price to rise even faster. The price rise will continue to accelerate
until the price falls back to its fundamental level.
Why the price is initially too high is a much murkier question. It could
simply arise from valuation mistakes, “irrational exuberance”, “animal
spirits”, or other idiosyncratic shocks.
Q: How can you tell if there’s a bubble?
A: You can’t. Not until it has already burst.
Anyone claiming to know that a current stock price is a bubble (or not)
is either fooling
themselves, selling something, or both.
A quickly rising price reflects either a legitimate increase in the
future earnings of the company, or a stock bubble – which case it is cannot
be told from current information. Remember that the fundamental price of
a stock should depend only on the future performance of the company.
We can only observe the price, but not the future – at least not without
a crystal ball.
People are wrong about their bubble predictions all the time. See below
for an extreme example.
Even after the fact, a large fall in the price could be either due to
a bubble bursting, or due to bad news which reduced the estimates of future
performance and lowered the fundamental price. Hindsight is not always
Q: Is there any difference between “irrational
exuberance” and a bubble?
A: Well, I shouldn’t put words into Alan Greenspan’s mouth, but I think
there is a fundamental difference between the two.
A bubble can be perfectly rational in the sense that everyone is making
informed and reasonable decisions. The investors simply demand a higher
rate of return on stocks that face a risk of bursting. Bubbles are not
On the other side, a stock that follows “irrational exuberance” may
be priced exactly according to fundamentals – e.g. perceived future dividends;
but may be completely irrational in the sense that the perceptions are
too high. In this case the prices are too high – not because of a bubble,
but because of mistaken expectations of the future.
Q: So what’s the bottom line?
A: A stock is worth what everyone else thinks it’s worth. If everyone
thinks eBay is worth 200$ a share, then it is worth that.
Does this price – does Dow 10,000 – represent a bubble?
Only if it pops.
Comment via the Bulletin
When the Bubble
Bursts by Lee E. Ohanian in the Philadelphia Fed’s Business Review.
Fundamentals by Joseph G. Haubrich in the Cleveland Fed’s Economic
Find the latest candidates for bubbles in the ISDEX
internet stock index.
Headed for Bubble
Trouble provides quite a few quotes from economists.
Transcript : Relationship Between the Stock & Bond Market, October
Trouble, NewsHour Report
The End of
Certainty in Economics Brian Aurthur on a different approach.
People who were wrong:
A Classic Investment
Bubble Is In The Making – PFA Newsletter: March 1998 “But Bubbles Always
Burst — It Will Happen This Year”.
The formula for the PDV of a (real) stream of payments given a real
V = x(t)/(1+r) + x(t+1)/(1+r)^2 + x(t+2)/(1+r)^3 + ...