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 • • • • 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