John Irons's Blog


Economic News, Data and Analysis


Interesting factoid of the day:
“For the first time since 1974, last month saw no initial public offerings (IPOs) – those new stock offerings that sometimes resemble Roman candles.”
New CEO motto: think profitable, not big |
Why not?
Looming war with Iraq? Better market environment ahead? Lagging effect of the stock market bust? Corporate scandals? Increased accounting scrutiny?
Anyone have any good ideas on this one?

Filed under: Economics, Finance

Bubble Confusion

In a recent series of articles in the Washington Post, yet another writer confuses the stock market with the economy. (See below.) I’ve fumed about this before (with nice graphs as well), but it looks like I need to say it again.
The “Bubble” of the late 1990’s was in the stock market. Various factors led to stock prices that were “too high” and that rose “too fast.” Eventually the stock market bubble burst, leading to large declines, especially in the technology sector.
The economic growth of the 1990s, however, was real: unemployment declined to record lows, growth was relatively high, incomes grew, and poverty declined. These were real things – cars, houses, ect. – and economic growth had real, tangible, positive consequences for real people.
Do not confuse the two! It was not a “Bubble Economy,” it was a “Bubble Stock Market.”
More on market bubbles

In a Bubble Economy, Recognition Comes Too Late (
By Steven Pearlstein
Washington Post Staff Writer
Sunday, November 10, 2002; Page A01
Mention the Bubble Economy and, for many Americans, it now conjures up images of shredded documents and half-built Houston mansions, depleted pension accounts and executives being led off in handcuffs. But it didn’t start out that way.
Roughly from 1995 through the end of 2000, the Bubble Economy was known as the new economy, and nearly everyone thought it was a marvelous thing.
Billions of dollars poured in from all over the world from people hoping to get in on the ground floor of the Internet, a medium that held the promise of transforming not only the economy, but life as we knew it. Stock prices rose higher and faster than at any time in history, making the ups and downs of the Nasdaq Stock Market a national obsession.
Now, of course, we know it wasn’t all real, and it certainly wasn’t enduring. Twenty months after it tipped into recession, the economy is barely growing. Stock prices are back where they were four or five years ago. And nobody is sure how much of the revenue and profit growth during the bubble was real.

Filed under: Economics, Economy, Finance

Stock Ownership

According to the Fed’s survey of consumer finances, stock ownership is now over 50% for the first time. (See below for the recent article on the current SCF.)
Why the increase? James Poterba looked at increased ownership between 1989 and 1998 and looked at various possible explanations.
-changes in risk aversion
-changes in transaction costs (monetary, information, increased adverstising)
-increases in product diversity
-changes in perceived risk and return
-changes in pension structure (IRA’s, 401k’s, etc.)
He concluded that “[t]he rapid growth of stock ownership during the 1990s has not been concentrated in any particular demographic or socioeconomic group, but rather reflects a broad increase in stock ownership across many different groups. The two most important sources of the growth in stock ownership, the expansion of retirement saving plans and the growth of investing in equity mutual funds, affected the middle and upper middle class more than they affected very high income households.” See The Rise of the “Equity Culture:” U.S. Stockownership Patterns, 1989-1998, by James M. Poterba.

2003 Recent Changes in U.S. Family Finances: Evidence from the 1998 and 2001 Survey of Consumer Finances, by Ana M. Aizcorbe, Arthur B. Kennickell, and Kevin B. Moore
Data from the Federal Reserve Board’s Survey of Consumer Finances show a striking pattern of growth in family income and net worth between 1998 and 2001. Inflation-adjusted incomes of families rose broadly, although growth was fastest among the group of families whose income was higher than the median. The median value of family net worth grew faster than that of income, but as with income, the growth rates of net worth were fastest for groups above the median. The years between 1998 and 2001 also saw a rise in the proportion of families that own corporate equities either directly or indirectly (such as through mutual funds or retirement accounts); by 2001 the proportion exceeded 50 percent. The growth in the value of equity holdings helped push up financial assets as a share of total family assets despite a decline in the overall stock market that began in the second half of 2000.
The level of debt carried by families rose over the period, but the expansion in equities and the increased values of principal residences and other assets were sufficient to reduce debt as a proportion of family assets. The typical share of family income devoted to debt repayment also fell over the period. For some groups, however–particularly those with relatively low levels of income and wealth–a concurrent rise in the frequency of late debt payments indicated that their ability to service their debts had deteriorated.
Full text (174 KB PDF)

Filed under: Economics, Finance

Interest Rates and the Stock Market

One of the most common questions that I am asked via email is why Alan
Greenspan’s remarks are so important for the behavior of the stock market.
The initial answer I give is that people interpret Greenspan’s remarks
as an indication as to the future direction of monetary policy as reflected
in interest rates. Of course, that leads to the obvious next question:
why do interest rates matter for the price of stocks?

Here are the basics.


The fundamental question about the relation between interest rates and
asset prices hinges on the relation between money tomorrow and money today.
A stock share (or some other asset) represents a claim to receive some
amount of money tomorrow (either through dividends or through what you
can sell the stock for tomorrow).

For example, if I buy a share of stock today, I expect to
be able to get some money for that share tomorrow. For example, I might
buy a share of stock for 80$ today hoping to get something like 100$ next

Now, if I happen to have some cash lying around, I could do a couple
of things with it. Either I could put the money in the bank or some other
safe asset (like government bonds) and earn some interest on the money,
or, I could buy that share of and get $100 in a year.

Since I have the choice, this gives us a way to value the share of the
stock. If the price of the stock were “low,” I would choose to buy the
stock. If it were “high,” I would choose to keep the money in bonds. But
how high is “high”?

Present Discounted Value

What we need to do is to compare the return on the two investments.
If the money I get from the bonds is less than the money I get from the
stock ($100), then I should buy the stock, and vice versa.

Lets say that the interest rate is 6%, and the price of the
stock is $P. If I invest in bonds I get $P * (1.06) in one year. If take
the $P and invest in the stock I get 100$.

This means that I will invest in if $100 > $P * (1.06). Or,
via quick algebra, if $P < 100 / (1.06).

If the price is above this value (100/1.06), I will sell the stock (and
so will everyone else), thus driving down the price. And if the price is
below, I will buy the stock (and so will everyone else), thus driving up
the price.

In equilibrium, this means that the price of the stock will be equal
to 100/1.06. In general, this means that the price will be given by 100/(1
+ i) where i is the interest rate expressed as a decimal
(e.g. 6% = 0.06).

So, the higher the interest rate, the lower will be the value (and
hence the price) of a payment in the future – a rise in the interest rate
thus causes stock prices to fall.

In general we can expand the above analysis to find what is called the
“Present Discounted Value” of any stream of future payments.

The formula for a stream {x1, x2, …} of payments in future
years is given by

PDV = (x1 / (1+i)) + (x2 / (1+i)(1+i)) + … .

(Of course, I am ignoring a range of issues involving expectations of
future interest rates, the value of the future payment, and risk. But the
simple case illustrates the interest rate effect.)

Internet Stocks

In addition to the conclusion that higher interest rates imply lower
stock prices, an obvious point from above is that the farther in the future
a payment is received, the less we will value the payment: $100 tomorrow
is worth more that $100 in 10 years. A second, less obvious, point is that
the value of an asset that involves a payment far in the future will be
more sensitive to a change in the interest rate than an asset with
more timely payments.

This second point becomes important when we are talking about internet
stocks. For most of the hot stocks, significant profits from the company
are, in many cases, not expected to materialize for years. So we can expect
that these stocks will be even more sensitive to interest rates
than the more traditional “old economy” stocks.


Try it for yourself – see how much of a difference a rise in interest
rates will make for the current value of a payment in the future.

The table below shows the value of 100$, payable either in its entirety
in 2 years, or $50 next year and 50$ the year after. Enter a value for
the interest rate and for a cahnge in the interest rate to see how much
the present value of the $100 in the future will fall.

function process() {
document.form1.irate2.value = parseFloat(document.form1.irate.value) + parseFloat(document.form1.dirate.value);
document.form1.pdv1a.value = Math.round(100* ((parseFloat(document.form1.val.value)/2) / (1+(parseFloat(document.form1.irate.value))/100) +
(parseFloat(document.form1.val.value)/2) / ((1+(parseFloat(document.form1.irate.value))/100) * (1+(parseFloat(document.form1.irate.value))/100)) )) / 100;
document.form1.pdv1b.value = Math.round(100* ((parseFloat(document.form1.val.value)/2) / (1+(parseFloat(document.form1.irate2.value))/100) +
(parseFloat(document.form1.val.value)/2) / ((1+(parseFloat(document.form1.irate2.value))/100) * (1+(parseFloat(document.form1.irate2.value))/100)) )) /100;
document.form1.pdv2a.value = Math.round(100* parseFloat(document.form1.val.value) / ((1+(parseFloat(document.form1.irate.value))/100)*(1+(parseFloat(document.form1.irate.value))/100))) /100 ;
document.form1.pdv2b.value = Math.round(100* parseFloat(document.form1.val.value) / ((1+(parseFloat(document.form1.irate2.value))/100)*(1+(parseFloat(document.form1.irate2.value))/100))) / 100 ;
document.form1.pdv1c.value = Math.round(100* ((parseFloat(document.form1.pdv1a.value)-parseFloat(document.form1.pdv1b.value)) / parseFloat(document.form1.pdv1a.value)) *100) /100 + “%”;
document.form1.pdv2c.value = Math.round(100* ((parseFloat(document.form1.pdv2a.value)-parseFloat(document.form1.pdv2b.value)) / parseFloat(document.form1.pdv2a.value)) *100) /100 + “%”;

Enter Interest Rate:

Enter Increase: 

Today’s Value (PDV) Today’s Value at the new interest rate % Change in Value 
Payable 50$ + 50$
Payable 100$ (year 2)

More Economics Features

Disagree? Post
in the Forum.

Links From the Web

Federal Reserve


on the Briefcase Indicator

Filed under: Finance

D10K A Bubble or not a Bubble

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
, 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
” 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
necessarily irrational.

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

See also:

People who were wrong:


The formula for the PDV of a (real) stream of payments given a real
interest rate, r, and payments {x(t), x(t+1), x(t+2), ...} is

V = x(t)/(1+r) +  x(t+1)/(1+r)^2 + x(t+2)/(1+r)^3 + ...



Simple Example of a Bubble.

Let’s say that, according to its fundamentals, is really
worth 100$ a share.

The price of Amazon, however, is 10$ overvalued and currently trading
at 110$ a share. Lets say that there is a 40% probability that the share
will drop down to the 100$ (plus interest) level in the next year.

price = 100 (1 + r) + b  with prob .60

      = 100 (1 + r)     
with prob .40

In order to induce people to hold amazon shares we must have that the
return to holding amazon shares be the same as a safe investment in T-bills,

100 (1 + r) .60 + [100 (1 + r) + b ] 0.40 = 110 (1 + r).

Some simple algebra shows that

b = 10 ( 1 + r ) / 0.60

so if the interest rate is 5%, then b = 17.5 and the price of Amazon
will be 122 1/2 tomorrow.

Over time, the amount of the overvaluation will be:

b(t+1) = b(t) (1+r)/(1-q)

where q is the probability of a crash.

This gives the price of over the next several years (assuming
the stock does not burst) as


Year Price Rate of Return 
1 110  
2 122 11%
3 149 22%
4 202 35%
5 301 49%
6 479 59%
7 798 66%
8 1362 71%
9 2357 73%
10 4105 74%

So, in order to induce people to hold stock, the rate of
return must be higher than the 5% safe return; and this rate of growth
increases over time.

Note that there is nothing “irrational” about this, people are perfectly
happy to accept the high risk, so long as they are compensated by the high


Filed under: Finance

A Standing Ovation for the Stock Market

Clap. Photo/Graphic: J. S. Irons.Look
ma! No hands!

The roller coaster ride ride called the stock market is back up today.
The Dow Jones Average was up 4.6% Tuesday after a 7.2% drop (the 12th largest
single day loss, and the largest point drop ever)
on Monday. Speculation abounds, as always, as to why the market jumps so

Yesterday, after the market closed, a parade of commentators spoke of
the market’s apparent “correction” and speculated about its future. Some
thought that the market was over-valued and that the drop was a natural
“re-alignment” of prices to fundamentals with the Asian Markets acting
as a trigger. Some though that the drop would continue, some not. With
the rebound today, I’d guess that just about half of the commentators were
proven wrong.

Ok. Fine. So like a great baseball player, the market sometimes needs
to adjust itself. The timing and the magnitude of these adjustments are
easy to explain after the fact, but hard to predict beforehand. One side
of the issue that has been neglected is the reason for why these adjustments
always seem to happen during the course of a single day of trading. Why
not a week, or a month?

Part of the answer, surprisingly, can be seen by thinking back to the
last time you saw a good concert.

Standing Ovation

The concert has just come to an end and the applause begins. “Wow”,
you think, “That was a great performance.” The applause gets louder, you
hear “bravo!” from someone in a seat in front of you. More applause…
what do you do? Keep clapping? Stop? Or rise from you chair for a standing

If you stand up for the ovation, what happens if you are the only one
who thought the performance was good enough to warrant an ovation? You
might end up the only one standing and looking foolish – not all concerts
end in an ovation. On the other hand, you could just wait in your seat
clapping to see if anyone else is willing to stand up, then join them if
they do. Also, if a standing ovation does occur, you don’t really want
to be the only one sitting.

Now think of an auditorium full of people just like you who might like
to stand (and who would if others were) but are not willing to take a chance
of being the first (and only) one standing. What happens? Typically one
person, or a small group, is finally bold enough to make the first move
and stand, then, very quickly, others in the auditorium follow and do the
same, followed by more and more (including those who didn’t necessarily
like the show but feel too embarrassed to be the only ones still sitting)
and in only a few seconds the entire auditorium is standing.

Information cascades

The parallel with stock market crashes (and rallies) should be obvious.
The end of the concert is like the opening bell on a day in which many
of the participants think stock prices are over-valued. A normal amount
of trading follows at reasonable prices- nothing too extreme until someone
or some small group “stands up” and a sell-off starts. Like the people
who liked the concert, the ovation rapidly encompasses the entire audience
and the market participants are selling like crazy.

No one wants to be the first and only one to start selling since the
market is still rising, but once the cascade begins, no one wants to be
the last to sell. The result is the one-day crash. The same happens in
the one day boom – no one wants to be the only person to by in a falling
market, but one things pick up, no one wants to be left out.

The parallel can be expanded by seeding the audience and the market
with people with better, or different, information. Say you are at your
first Jazz concert and that you know very little about both the music as
well as the ovation habits of typical Jazz audiences. In this case you
are more likely to be a follower and to do what ever the better informed
or more experienced people in the audience do. If they liked the performance,
and stand you will gather that it was a high quality show and that standing
is appropriate, and thus you will be more likely to stand.

In the market case, one a sell-off starts people may be thinking “hey,
maybe they know something I don’t” and will follow the trend, since the
information generated by some trades helps to inform others about what’s
going on. Alternatively, the selling by others may confirm your beliefs
and give you more confidence to act on them.


The above ovation analysis began by looking at “micromotives” – the
actions of a single individual or investor in a larger group – and wound
up explaining “macrobehavior” – a standing ovation or market crash.

This style analysis is certainly nothing new to economics – it’s roots
go at least all the way back to Adam Smith. It is not, however, an easy
process to move from a description of individuals within a group to the
behavior of the group as a whole – especially if there are important interactions
between the individuals. If we wish to further complicate things by introducing
any kind of informational or other kinds of heterogeneity into the population,
it becomes very difficult to understand the macrobehavior of the system.

Computers are helping in this regard as it is becoming possible to simulate
a large group of interacting artificial computer generated “people” to
see what happens in, say, a market or an auditorium. The field of “Computational
Economics” is developing along these lines.

Elvis has left the building, Elvis has left the building.

I think everyone has had the experience of standing too long at the
end of an ovation – the feet start to tire, the hands get sore from too
much clapping. So now that a standing ovation has started, or a crash has
taken hold, how do we stop it? What we need is for some common signal to
coordinate our actions.

It was hoped that the circuit breakers would be able to provide this
signal and the worst of the crashes would be avoided. The fact that the
first circuit breaker did not stop things on monday means we need a better
signal (although, what would have happened without them is still an open

It does appear that turing on the house lights and ending the day at
the market does help, since, as usual, a large rebound followed the cascade.

Or maybe it was just a good night’s sleep.

See Also:


October 97. Not the biggest
drop or gain in history.

The market has seen considerable swings in the past few days; however,
despite the claims of many media outlets, the DJIA has not been
down and up by record amounts. 

It is true is that the absolute point gain has bounced around
by record amounts, but… well… so what? What really matters is the percentage
gain in the market. 

Today the market was up by nearly 4% after loosing around 6% on monday.
Compare this to the 1987 crash of 22.6% and the following rally the day
after when the market rose by nearly 6%. 

In point terms, a crash of the 1987 magnitude would have meant around
a 2,000 point drop in the dow today. 

The “crash” on monday was in fact only the 12th largest crash in history.
The only reason it seems so big is that the absolute number of the drop
seems “large” – but since the overall level of the market is so high, the
percentage drop — which is what we really care about — is not quite as


Points %Change

October 19 

October 20



October 27 

October 28






Filed under: Finance

Yes, we can learn from our mistakes

Immediate policy response prevented 1987 from becoming another 1929.

The magnitude of the 1987 stock market crash was much more severe than
the 1929 crash – a drop of 22.6% versus 12.8%. The loss to investors amounted
to $500 billion. Over the four day period leading up to the October
19th crash the market fell by over 30%. By today’s level’s this represents
a 2,200 point drop in the Dow. However, while the 1929 crash is commonly
believed to have led to the Great Depression, the 1987 crash seemed to
have no lasting effect on the real economy.

Why not?

A good case can be made that quick policy action on the part of the
Federal Reserve and the Treasury deserves some of the credit. This stands
in stark contrast with monetary policy blunders that contributed to the
Great Depression.

Why does a crash matter anyway?

So investors lose some money in a crash – why should this matter for
the real– i.e. non-financial– economy? The problem arises when the drop
in the book value of of investments causes widespread bankruptcy and the
closing of doors. If financial houses were forced to close down, then the
availability of funding for investments would be reduced, hurting the ability
of firms to increase or continue production. As the ripple of financial
institution closings makes it way through the economy, firms producing
goods and services would eventually feel the bite of the reductions of
loan availability. In the 1930’s this meant a Depression.

The Policy Reaction

After the largest one day drop in the market in history, the Federal
Reserve took immediate steps to increase the supply of liquidity in the
market. The goal was to prevent bankruptcies, which would eventually hurt
the real economy, by making loans to the investors than were in danger
of running out of money. The strategy appeared to have worked, and the
Fed certainly earned it’s title of “lender of last resort”.

Policy makers themselves were also quick to respond. Alan Greenspan
in a statement said that “The Federal Reserve, consistent with its responsibilities
as the nation’s central bank, affirmed today its readiness to serve as
a source of liquidity to support the economic and financial system.” President
Reagan said
“…I think everyone is everyone is a little puzzled because…
All the business indices are up. There is nothing wrong with the economy.”

Still Learning

As the 1987 crash demonstrated, we are still learning. Since the crash,
a number of regulatory changes have been made to try to prevent another
severe “panic” drop in the market. Trading curbs and “circuit breakers”
to prevent mass sell-offs by computer traders have been instituted with
this goal in mind. So far, there has not been a crash of close to the same
magnitude as the 1987 or 1929 crashes – but only time will tell if they
will continue to prevent panics in the market.

For more on the Crash of 1987 see The Mining Co.’s 10th
anniversary special

See Also:

Filed under: Finance