Herds inflate bubbles and deflate them, but investors and financial economists are still debating the meaning of bubbles and their existence. Charles Kindleberger defined a bubble in his book Manias, Panics and Crashes as "an upward price movement over an extended range that then implodes." That definition is neutral. It does not tell us whether the prices of stocks, houses or mortgage-backed securities exceed their true values as bubbles inflate, or whether prices merely track values as values increase. But the word bubble has come to be associated with overvalued investments, where prices exceed values. Bubbles are contentious because their existence implies that markets are not efficient. The efficient market hypothesis, in its extreme form, claims that prices never deviate from value, so bubbles are evidence that markets are not efficient.
Typical institutional investors believe that not all markets are efficient and that even markets that are efficient most of the time are not efficient all the time. Indeed, typical institutional investors attempt to beat the market by identifying deviations of prices from values, buying investments whose prices fall short of values and selling investments whose prices exceed values. In this way, institutional investors deflate bubbles. Institutional investors buying investments whose prices fall short of values drive prices up, closer to values, and institutional investors selling investments whose prices exceed their values push prices down, closer to values. At times, however, institutional investors attempt to beat the market by riding bubbles, inflating them at first and dismounting before they deflate. This is what hedge funds did successfully at the time of the technology bubble. Hedge funds bought overvalued technology stocks in the late 1990s, inflating the bubble, but dismounted before it began deflating, selling these stocks. This "greater fool" plan, in which investors buy overvalued stocks planning to sell them later at even higher prices, has worked for hedge funds. But it does not work when fools are unable to find greater fools. Indeed, it was mostly individual investors who bought technology stocks from hedge funds when the bubble was fully inflated.
Individual Investors In Bubbles
The Shanghai Composite Index of Chinese stocks multiplied more than fivefold in the two years from October 2005 to October 2007, but it was decimated by October 2008, losing more than two-thirds of its peak value. "The market was going wild," said an investor in April 2008 after the market lost almost half of its value. "Everybody was talking about how much they had earned, how much more they would invest, and which stocks had jumped 20 times, or even 30 times." "These days, my family quarrels a lot," said another investor. "My husband asked me to sell; I wanted to hold for a while. Now my husband condemns me as so stupid that we lost our family's savings."
The University of Michigan's surveys of consumer attitudes and behavior reveal that individual investors are bullish when they expect the economy to expand, believing that stocks provide the best of all worlds, combining high returns with low risk. The same investors are likewise bearish when they expect the economy to contract, believing that low returns with high risk are forthcoming. Moreover, they adjust their portfolios to fit their beliefs, moving money into stocks when they expect the economy to expand, and shifting money out of stocks when they expect the economy to contract. Yet they are misled by bullishness and bearishness more often than they are led right. Stock returns tend to be low in months following high readings of consumer confidence.
Extreme bullish sentiment is often accompanied by proclamations of "new eras," with returns higher than their risks. In the late 1990s, some stock market seers prophesied that the Dow Jones Industrial Average would reach 36,000 soon, as investors learned that stocks are no riskier than bonds yet yield much higher returns. And in 1930, after the crash of 1929, George Frederick wrote: "By far, the most significant thing that the October-November 1929 stock panic did was to put the acid test to the so-called new era [that] was all rainbows and sunshine, and was bombproof. ... Wiseacres now recall that prophets of a new era usually appear just before a panic deluge."
The soberness of Frederick following 1929 resembles the soberness following the late 1990s. New eras do come, but returns higher than risks are rare. "There had been recognition by sound, conservative economists that there really was a new era," wrote Frederick. "What then happened was that the unrestrained optimists, the opportunist bankers, the greedy stock promoters and the unthinking public began, pell-mell, to discount this new era for years ahead, and overreached themselves. The new era set up new standards, but the unthinking seized upon them as license to indulge in unrestrained imagination and unlimited standards of valuation."
Many individual investors thought the stock market was overvalued in the last six months of 1999, following immense stock returns, yet many of them thought that buying stocks was a good idea. Fewer individual investors thought that the stock market was overvalued in the six months ending in July 2002, following precipitous declines in stock prices, yet few thought buying stocks was a good idea. Almost half of the individual investors surveyed by Gallup thought that the stock market was "overvalued," as in a bubble, in the last six months of 1999, while fewer than one in 20 thought that the stock market was "undervalued." The proportion of individual investors who thought that the stock market was overvalued declined to approximately one in four in the six months ending in July 2002, and the proportion of investors who thought that the stock market was undervalued increased to almost one in five.
Gallup asked investors at those points if they thought they were good times to invest in the financial markets. We presume investors were more likely to answer "yes" in 2002, when they tilted toward the conclusion that the stock market was undervalued, than in 1999, when they mostly thought it overvalued. Yet these were not their answers. In 1999, investors judged the market overvalued yet believed it was a good time to invest.
Fewer investors judged the market overvalued in 2002 than in 1999, yet fewer investors thought in 2002 than in 1999 that it was a good time to invest. Only one-quarter of investors in both periods, according to Gallup, believed that the stock market was "valued about right," a belief consistent with market efficiency, implying that individual investors who believe that the market is not efficient outnumber those who believe that it is efficient by a ratio of three to one.
The Flash Crash
We tend to focus on bubbles lasting years, but bubbles can also last days, hours or minutes. There are also "negative bubbles" in which prices deflate rather than inflate. The "flash crash" of May 6, 2010, is a recent example, where the Dow Jones Industrial Average plunged almost 10% within five minutes, erasing a billion dollars of market value. Stocks that had been selling for $40 were a few minutes later selling for a penny. The flash crash likely originated when an investment company sold a substantial quantity of futures contracts on a stock index, causing a decline in its price. The decline in price triggered a computerized herd, which proceeded to sell stocks, as programmed, until humans stopped it.