Uploaded by Harry Stocks

Bubbles and Crashes

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Bubbles and Crashes
Alternative definitions
• Mankiw defines bubble as when “asset price rises simply because
people expect it to rise”
• Blinder defines it as “large and lasting deviation of asset price from its
fundamental value”
• Shiller defines a bubble as “situation where news of price increases
spurs investor enthusiasm which spreads by psychological contagion,
• …in the process amplifying stories that might justify the price increases
• …and bringing in a larger and larger class of investors who, despite doubts
about the real value of an investment
• …are drawn to it partly through envy of others’ successes and partly through
a gambler’s excitement”
Testing growth vs. bubble
• Shiller and Mankiw agree that P/E ratio is helpful in identifying stock
price bubble
• Why?
• Propose empirical test of growth vs. bubbles
• If high P/E due to growth, stock price should stay high
• If inflated, stock price should subsequently fall
• Are these statements correct?
• Mankiw reports Campbell-Shiller test on companies 1918-2000
• Compare P/E to subsequent 1-year stock price
• Are results definitive?
Crashes
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Good theory of bubbles should also explain crashes
Mankiw: “Crashes are hard to explain with classical theory of asset prices”
Some reflect reversal of underlying factors: interest rates, earnings
Others reflect burnouts of bubbles
• Burnout can be triggered by events, information
• Downturn can accelerate just as bubble can accelerate
• Cassidy notes in 2000:
• Began to be more days with large declines
• Isolated stocks had major declines (though often partially recovered)
• Trade press, Wall Street research started to raise questions
• Weak fundamentals for some stocks: cash burn rate, profit expectation, P/E
• Some analysts started recommending caution
• Margin calls accelerated downward trend
Some crashes hard to explain
• In October 1987, Dow fell 23% without any event or news
• In 2010, “flash crash” caused Dow to fall 9% in 30 minutes
• Appeared to be caused by one firm’s attempt at trades
• Resulted in controls on stock price movements: “Circuit breakers”
• Despite new controls, in 2015 stock market fell more than 5% in
single day
• In 2017 Ethereum dropped from $300 to $.10 (10 cents) in minutes
2010 Flash crash: May 6, 2:45 pm
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