J. Psychology and Financial Markets 2001
The Real Year 2000 Problem: Investor Psychology
By
Gunduz Caginalp, Editor
With the approaching
Millennium, financial markets contemplated the possibility of a large-scale
computer program glitch that became known as the Year 2000 problem. Ironically,
there was no significant problem with the technology, but a short circuit
occurred with the shares of many Internet related technology shares. Investor
psychology shifted from strong enthusiasm at the beginning of the year to panic
and, then, disenchantment toward the end. The crowd psychology that moved
prices beyond even the most optimistic estimates for earnings or even revenues
in the early part of the year worked in the opposite direction for much of the
remainder of the 2000. As we moved
further into the year, the sky-high valuations of many of these shares began
their relentless descent. The V-word (for
value) emerged after a long absence.
The extraordinarily high
prices and total market capitalization during the late 1990's for these shares
exceeded even the most sanguine estimates of future earnings. Many of the new
high-tech companies had never shown a single year of positive earnings. During
1998 the absence of earnings led to an emphasis in good revenue growth. By 1999
even this criterion became too restrictive for the general investor as
companies soared prior to any significant revenues. Paradoxically, this was
especially true of Internet-based retailers, or e-tailers, which would
undoubtedly face tremendous competition from almost any company that was
willing to invest a modest amount into setting up a Web site. Public companies
such as Etoys and Ivillage rapidly rose to a market capitalization that rivaled
some of
Moreover, technology
companies that possessed an intriguing idea but no real revenue also rose to
dizzying heights. In years past, investors would attribute some value to an
idea, but not one that would assume a lock on a significant fraction of a
market that was yet to materialize.
Over-valuation and
over-enthusiasm was at an extreme for many technology related initial public
offerings (IPO’s). Most extraordinary among these was VA Linux, a company that
markets an operating system for networks. Late in 1999, the IPO was originally
priced in the teens and upgraded to about $30 shortly before it was launched.
An analyst noting the potential market and growth for this software took the
unprecedented step of placing a five-year target price of $300 for the stock
even before the first share was traded. This widely publicized price target in
a frothy IPO market led to an opening price of about $300 for the stock. After a year of trading, the stock was near
$10, somewhat below the initial projections for the IPO price.
Underlying this example is
the theoretical issue of why stocks should rise in price (beyond adjustment for
interest rate returns) if we can calculate the expectation value with a set of
probabilities. Perhaps, some would
assert, this is a more modern, scientific and efficient way of gauging true
valuation. If the outcome of an idea and marketing plan could be predicted to
have such tremendous economic consequences, then why not pay close to that
price at the outset?
This is a question that can
be asked within a more abstract setting of a laboratory asset market. Suppose,
for example, that an asset will have a payout at the end of 10 trading periods,
and that the participants are told that the “earnings,” or change in the
expected payout will change each period. Suppose the traders were to know what
the expected payouts will be during these 10 periods; for example, that there
would be 50-50 chance for a 30% increase or a 5% decrease. Then the traders
could calculate, at the outset, a valuation that would be constant for the
entire experiment, since all changes have already been incorporated into the
expected payout. Thus one might argue that the rising of share prices as a
company matures are perhaps unnecessary, and the ultimate valuation could be
priced at the first trade of an initial public offering.
One reasonable answer to
this paradox is that we do not know the probabilities (such as a 50-50 chance
of 30% increase or 5% decrease) at the outset; the investors merely deduce them
in time. For example, we do not really know the potential profit to be made on
a particular computer operating system. As the years go by we can acquire a
better idea of those probabilities, which in turn, will allow us to recalculate
an expected value of the shares. This concept may be regarded as ambiguity
rather than risk. The latter is usually assumed to have a well-defined
probability distribution. The concept of ambiguity might be described in a
mathematical or experimental setting by means of an urn from which different
color balls are to be drawn. Each color represents a percentage change in
valuation, but we do not know the initial distribution of the colors. We merely
make conjectures as we see the draws. After many such draws we may feel that we
have a good idea about the approximate chances for each color, at least for the
next few draws. At this point the ambiguity is transformed into a probabilistic
expectation value, but only if we know for a fact that new balls are not added
to the urn in the meantime. In the world we live in, there are always new
factors to be added, so that the ambiguity is always present, and more so in
the newest markets and companies.
There are many factors
involved in the spectacular rise and fall of perhaps the world’s greatest
bubble to date. For many established
companies that traded at triple digit price/earnings ratios, the valuations
were not very different from the most recent bubble in the Japanese stock
market that ended in 1990, or some components of the
The full magnitude of this
most recent bubble, however, was exhibited in the companies that were public
for a relatively short time and valuations were exaggerated even by the lofty
standards of the late 1990's. The level of public participation, media
attention and advertising appears to be greater than any other stock market
bubble. With the arrival of Internet
trading and nonstop business news, the public was able to take part as never
before.
The extent of over-valuation
is difficult to assess in this recent bubble, since there was considerable
variation among the different companies. At one extreme, numerous companies
with market capitalization in excess of $1 billion witnessed declines of 99% or
more without significant change in their business activity. For stocks in this
category, the high-tech bubble dwarfs many of the legendary bubbles in which
assets lost 90% to 95% of their value within a comparable time frame.
Some basic questions come to
mind immediately. Was the nature of the
bubble known to those who were underwriting it? The IPO market appeared to add
fuel to the flames as each week featured a new set of IPO’s that rose
spectacularly. For many technology issues the IPO was often oversubscribed and
a large number of buyers waited to buy the shares at the first opportunity.
Retail investors lucky enough to obtain
an allotment of the IPO were usually restricted from selling for a month lest
they be banned from future IPO’s. Short selling is not usually possible until
the fourth day after the pricing. Without selling on the part of many retail
investors, the institutions had a considerable degree of control on the price
during the initial days. For investment houses that were able to pick the most
appealing ideas and arouse public eagerness to buy them, the business was
lucrative. Prices rose to ludicrous proportions as analysts were defending more
and more surrealistic methodology. Early
in 2001, analysts found themselves downgrading, for the first time, some of
these IPO’s when they had fallen to a fraction of the IPO price and a small
percentage of the all-time high price.
The media attention on the
IPO’s served to entice a public with stories of 100%, 400% and even a 1000%
profit in a single day. Much attention
was focused on fairly inexperienced people, e.g. the CEO of the new company,
acquiring (at least on paper) a net worth of hundreds of millions or even
billions prior to making a dollar of profit for the company.
Despite sensational
appearances, the media cannot be blamed for the frenzy that surrounded the
investment world. In most cases, they reported the news accurately, and in a
timely manner as the technology of cable and Internet made possible. When an
IPO increases by 1000% in its first day, turning a few people of modest means
into instant billionaires, it would be difficult to report the story accurately
without the sensational impact. In fact, much of the media was rather
conservative and cautious in its approach to these phenomena. The Wall Street
Journal and its sister publication, Barron’s, repeatedly warned of the surreal
atmosphere surrounding the rise in these prices. Often, readers responded in
letters by saying the paper was being old-fashioned and incapable of
understanding the New Economy. Unlike the Old Economy these New Economy
companies could develop at a much faster rate in cyberspace, their advocates
said. And there was some truth in this. For example, the time interval between
the first and one-millionth customer for Sears is surely much longer than the
corresponding interval for Amazon. Of course this ratio does not immediately
translate into profits since the development of a rapid customer base is also
possible for the competition and pricing of goods must account for that fact.
As many of the news articles stated, it is possible that the main economic
beneficiaries of the New Economy technology could be the consumers.
Unfortunately, the roles of
some of the Internet trading brokerage firms were not nearly as responsible.
The years prior to 2000 featured a collection of e-trading commercials that
could be viewed as hilarious by the seasoned professional and convincing by the
novice trader. A typical commercial began by showing a teen-age boy or an
elderly woman who appear to be very ordinary, and are treated as such. In the
next scene, the other characters, and no doubt the viewers, are surprised to
find out that this person is being thanked for bailing out a country, for
example. The strong suggestion is that anyone who has a modest savings account
can acquire a fortune, and be treated accordingly, if only they start trading
on the Internet. For any skeptical viewers having their doubts, a resumption of
the news, particularly the business news cable stations, would often turn to
factual stories of the day’s new IPO billionaires.
Throughout this meteoric
rise of the Internet related technology stocks, the group of people known as
analysts had an interesting and difficult role. They are asked to assess the
future earnings, revenues, etc., and estimate a price that is likely to be paid
in the future. Their job was highly complicated during the late 1990's for
several reasons. One is that someone sticking to any reasonable business
measures would simply be asserting that these stocks are too richly valued, and
therefore, should be sold. As prices
soared beyond these levels, however, it places the analyst in the tenuous
position of recommending holding no stocks in his group. An analyst restrained
by realistic forecasts is also subject to peer pressure as prices catapult
beyond these levels. Social psychologists have long addressed questions related
to the pressures on an individual making an assessment of, say, $10, when
everyone else is making assessments ranging between $100 and $200. Another reason is that an analyst who is part
of a large investment company is aware that his parent company stands to make a
tremendous profit from underwriting and other activity. Thus any effort to restrain the price to a
realistic value is detrimental to the analyst’s parent company and also leaves
the analyst behind as prices vault beyond valuation.
Consequently, analysts
sought more creative ways to estimate target prices. With near unanimity among analysts who are
presented to the public as experts, the psychological hurdle is daunting for
the individual or institutional investor who attempts to seek a more realistic
view.
As some recent research has
shown in the laboratory, momentum is a key factor in bubbles. A self-feeding
mechanism is established as rising prices lead to more buying which raises
prices. A tempering influence to momentum is trading based upon fundamental
value. As analysts de-emphasize
fundamental value, and new investors are mesmerized by prices, while
insufficiently equipped to gauge value.
The advertisements only served to further redirect new investors toward
looking at price changes and ignoring fundamentals.
All of this could not be
possible without a huge amount of excess cash, sometimes called liquidity,
available to enter the market and push prices higher. Demographic factors,
together with a booming economy and low interest rates, ensured a steady flow
of additional cash into the market. The baby boomers that had previously
swelled the ranks of college students in the late 1960's, increased the demand
for consumer goods and energy in the 1970's, and pushed up housing prices in
the 1980's, were now in their prime earning years and putting more money to
work in terms of savings and retirement.
As parts of this money flowed into the equity markets, some asserted that
this might continue for many more years until the baby boomers reached
retirement. Of course, in the marketplace any large demand has the potential to
be met by a large supply, in this case the huge supply of IPO shares as well as
secondary offerings.
During this bubble, the
excess cash provided by the demographics was enhanced by a wider participation
of the general public than in previous eras. The lower commissions available
for small accounts through Internet trading, the wider hours for trading, the
rapid access to information through high tech communication all contributed to
this wider participation. Of course, the nature of the advertising and the
media attention served to enhance the self-feeding spiral.
One way to begin addressing
the question of how this bubble evolved is to find the beneficiaries and
victims. As the advertisements told of riches for the novice trader, while
charging only $5 or $10 trading commissions, the novice trader was usually
unaware of the additional cost in terms of the bid-ask spread. For a volatile, non-listed stock, the bid-ask
spread would generally amount to a fairly substantial cost for frequent
traders. For many novice frequent
traders, the total paid in such costs would ultimately far exceed their profit
if any. For many of the newly public
companies, the underwriting fees plus the possibilities of selling some of the
shares held during the days following the launching of an IPO, provided a
lucrative business for many of the large investment houses. The losses were often borne by the retail
investors that believed the hype by the analysts, and had confidence in the
name of the investment house.
The marketplace will always
have a spectrum of participants from the most highly informed to the least
informed. The Efficient Market Hypothesis (EMH) depends upon a mechanism of
arbitrage which is an idealization that assumes the existence of many different agents with diverse interests.
When the participants belong to one of a few distinct groups each with its own
interests, the basic assumption is far from valid.
The causes of a bubble are
closely related to its bursting. The momentum that raises prices works in
reverse on the way down. Various studies have demonstrated that open-end funds
that terminate new cash inflows in order to limit their assets often do not
perform as well subsequently. This suggests that the inflow of new cash, with
which the manager buys more of the stocks he owns, leads to pushing up of share
prices. At least one does not need to do large scale selling that pushes down
prices. Once the cash flows are directed outward, the situation is exactly the
opposite. The mutual fund must necessarily sell some of their positions,
thereby lowering the prices of the shares they own, leading to more redemptions
by investors in a vicious cycle.
Like the legendary South Sea
Bubble, the Internet bubble was sparked by a new frontier. The South Sea Bubble
stimulated the imagination about the riches to be discovered in the
Inevitably, one wonders
about the timing of the market peak. The same segments of the market had been
overvalued in 1999 and earlier. What were the factors in the first quarter of
2000 that finally resulted in a downturn? Lowered earnings expectations and a
background of higher interest rates were the most fundamental changes that the
year 2000 ushered in. Many speculative bubbles had ended with a calendar year
as investors with large gains hoped to postpone the capital gains tax. The high
tech market may have been in a similar situation in late 1999 as well. However,
early in 2000, value-based investors faced another challenge when the AOL
merger with Time-Warner was announced. The fact that the lofty AOL share price
would be exchanged for the more conservatively valued Time-Warner meant that a
group of experienced businessmen, not novice traders, were valuing AOL’s stock
at these prices. Perhaps this re-evaluation that spilled over to other stocks
served to prolong an overextended market that was already to topple. Many of
the stocks in the Japanese high tech market were even more fanciful in terms of
valuation. At the end of the first quarter of 2000 cash flow problems were
threatening some of these companies. The pro-business prime minister also
suffered incapacitating health problems that prompted further selling in
Perhaps the bubble could
have been punctured at any time by the announcement of a large-scale failure in
the Internet related business. It turned
out that such a clear, visible signal was not needed. In the early spring of 2000, Barron’s
published a list of companies along with the number of months they could
survive in terms of cash flow. Although many skeptical articles had been
published in Barron’s, this was very precise in setting a finite time horizon,
in some cases, weeks, before the companies would be incapable of functioning,
and presumably seek bankruptcy protection. Several investment houses also
seemed to have a change of heart shortly after this time. As the selling
started, much like the corrections that had occurred in previous years, some
large hedge funds were forced to liquidate significant blocks of shares. During
many market debacles, there is a point where the value-based investors will buy
at a particular point irrespective of the prospect of further decline. In this
case, however, the fundamental value, as assessed by these investors, was so
much lower than the prevailing prices, that for all practical purposes, there
were no buyers. The free fall had started.
In the years to come,
scholars will undoubtedly study the causes for the bubble and the factors that
made it so extreme in some aspects. The
Journal of Psychology and Financial Markets enters it second year during these
provocative times in finance. From a scientific perspective, the events of 2000
provide a rich data set that will challenge theorists in economics, finance,
psychology and other disciplines. Accordingly, we plan to feature works that
study the various aspects of the remarkable market phenomena we have witnessed
during the past few years.