Behavioural Finance View on Market Bubbles - Essay Example

Market Bubbles In financial and accounting practices, the terms market bubbles and behavioral view are not new since the introduction of rational expectations regarding economic models. A market bubble in economics refers to a sharp abnormal rise in the market price of a commodity or a set of commodities consistently, with the initial increase in the prices generating expectations on future rises, thus, attracting speculators whose interest lies in the trading profitability of such commodities rather than their earning capacity. In the past, there have been several market bubbles followed subsequently by market crashes, some of which include the Tulip mania in the 17th century, the great market crash of 1929, the dot com mania of the late 1990s, and the recent sub-prime mortgages and the Collateral Debt Obligations crisis. This paper investigates these market events through relevant research material and identifies the anatomy and behavioral finance phenomena of the events using information. The tulip bulbs speculation, which was at its peak in February 1637, and the consequent market crash that followed mark the most notorious economic hard times in the History of Dutch (Goldgar, 2007:5). Together with Britain’s Sothern Sea Buble in the 18th century, these are the earliest example of irrational market behavior that affected investors in Europe. The Semper Augustus, a tulip bulb type, was both sublime and prosaic than any comparable bonds or stocks, it was extraordinarily beautiful with its pure white top and midnight petals combined with accents of crimsons flares. In history, it remains the most valuable flower to date. Back in the early 1624, an individual in Amsterdam in possession of the last dozen specimens of tulips was o be given a high of 3,000 guilders, an equivalent of a wealthy merchant’s annual income, but turned down the offer. This is the height of how speculations had raised the prices of the tulip. Nonetheless, the tulip craze was not only in Dutch. The flower was an enchantment for the rulers of the Ottoman Empire and the Persians in late 1550s, but it was in Holland where the flower found its fertile ground, economically (Goldgar, 2007:15). Holland was in the Golden Age in the early 1700s and all the resources that the country had directed towards the fight with Spain for their independence were now concentrated on commerce. Amsterdam was strategically at center of the East Indies trade, which enabled a single voyage to gain four times its value in the lucrative market place. Flower gardens surrounding their grand estates usually evidenced their success in the trade. This was the trigger for the tulip craze. Tulip prices began rising significantly as the rich lot in Holland not considering the value of the tulips. The tulip business became the new order of business setting by professional tulip traders with the customers coming from tulip fanciers (bloemisten) in middling groups rather than the nobles or artisans. The enthusiasm of owning prized specimens of tulips was a cultural credential display. The cultural credential associated with the tulips, combined with the fact that the seed takes seven years to grow, and that a mother bulb can only last a few years, was the foundation of the supply crisis. There were many buyers for the bulbs with a limited supply, which in economics results to a rise in the price of the commodity (Goldgar, 2007:86). The prices of the bulbs rose consistently over the early 1930s because of more speculation. The farmers and traders mortgaged all their assets in order to raise more capital for the trade. By 1936, any tulip bulbs, even the ones the current society considers garbage, could simply trade for hundreds of guilders. The peak of the tulip mania was in the early 1937 when a single tulip bulb could change hands up to a maximum of ten individuals in a single day. The exact all time high of the tulip trade was at an auction whose proceeds would benefit seven orphans who had inherited 70 tulips from their father. The rare bulb, Voiletten Admirael van Enkhuizen, was to sell for 5,200 guilders, but raised close to 53,000 guilders. Arguably, this was an obscene amount even by today’s standards. The tulip market crashed soon after, beginning in Haarlem. Desperate traders could only sell their tulips at one-hundredth of the amount that a few weeks before was selling at 5,000 guilders per bulb (Goldgar, 2007:132). Economic critics however downplay the seriousness of the tulip mania saying that a relatively small group of individuals was concerned with the trade. In addition, they claim that such high prices may have been true. Nonetheless, the tulip trade was a financial crisis for those involved, and the main cause of the event was over-speculation in the market. The Great Depression of 1929 was the most devastating economic slump-down in the twentieth century that started in the United States and spread throughout the world. In November 1929, the stock market crashed literary reducing the paper value of stocks by 33% (Galbraith, 2009:12). Industrial leaders and politicians began giving the citizens hopes with the assumption that the situation could not get any worse, little did they know that the stock value would go down to less than a fifth of the initial value in 1929. The result was closure of factories, shut down of major business houses, and failure of majority of banks. By 1932, one out of four American citizens was jobless. The Great Depression began with the collapse of New York Stock Exchange prices, declining to the 20% of the initial value of the stocks. The stock market crash ruined thousands of investors, as well as financial institutions, with emphasis on the financial institutions that were holding stock portfolios. The result was the insolvency of more than 11,000 banks out of 25,000 banks in the US at the time (Rapp, 2009:131). The significant failure of the banks and the looming loss of confidence on the prevailing economy resulted in less spending, and consequently production, thus the tumbling of the economy further. By 1932, the output had reduced and the unemployment rates in the country were rising, approximately 15 million people or 30% of the national workforce. The most affected countries were those that were indebted to the US like Great Britain and Germany. In Britain, the export and industrial sectors were affected seriously, with the slump down having a more profound effect in Germany, including unemployment rates of close to 25% (6 million) of the workers in 1932 (Galbraith, 2009:89). In the wake of the Great Depression, almost all nations aimed to protect their domestic production by raising existing tariffs, imposing new ones, and quota system on foreign importation. These restrictive measures led to significant reduction on the volume of international trade, more than half of the initial volume before the market crash. Unemployment levels in the US were soaring, those who retained employment had the choice of wage cuts, and layoff notices (Rapp, 2009:129). The majority of the population filled in charity lines and soup kitchens were the new food joints for the “middle class”. Desperation was setting in, with thousands of individuals taking up jobs from laundry to vending apples. The effects were varying in magnitude. Oklahoma was among the hardest hit states in the US, especially resulting from the drought. The “Dust Bowl” forced the residents of the state to migrate west t avoid the winds. The causes of the Great Depression were partly due to the imbalances and weaknesses of the US economy resulting from the speculative euphoria and boom psychology of the early 1920s. Nonetheless, the event was a turn-around in government policies and economic theory. Consequently, it heavily contributed to the rise of Adolf Hitler, as the Nazi’s munitions production and public works projects ended the Depression around 1936 (Galbraith, 2009:128). The Great Depression came to a complete end shortly after the US entered into the Second World War in 1941. The dotcom bubble, or information technology bubble, or internet bubble, was a result of the combination of speculative and fad investing, availability of capital funding for initial startup, and lack of profit of the dotcoms (Melamed, 2009:23). Investors were pouring money for the startup of the internet in the mid-to-late 1990s hoping to gain profits from those companies. The dotcom market crash was a rapid rise in equities fueled by investments in companies dealing with internet. Consequently, the value of the equities grew exponentially, with the then internet-dominated stock exchange NASDAQ gaining a peak to 5132.52 points in late 1999 and 2000 from 1000 points in 1995 (Rapp, 2009:182). This was because Cisco, Intel, Dell, and Microsoft were the four powerhouses of the NASDAQ resulting from market capitalization dominance. The rising stock prices, market confidence, individual speculation, and availability of venture capital resulted in a market environment where many inventors overlooked the price-to-earning ratio (P/E) with the lure of an advancing technology in the internet. Interestingly, the dotcom bubble began even before the World Wide Web. The dotcom craze began in 1992 with the publication of the features the “information superhighway”. Of particular emphasis was an on the Business Weekly magazine on May 31, 1993. However, some critics say that the publications did not mention the internet. They claim that the imminent arrival of the internet was thus not a catalyzing factor. Rather, the bubble was a result of other investments not appearing to generate huge profits thus making the dotcom investment a viable option. Before 1994, telecommunication and technology-based companies were only interested in the production of smarter phones (Melamed, 2009:39). The craze swept the television companies with the promise of interactive television with 500 channels, video on demand, and interactivity. However, the much-speculated growth of the technological sector was an illusion. Proceedings targeting the dotcom companies for engaging in unscrupulous business like monopolies (Microsoft) were the order of high profile cases. The market began experiencing corrective measures with reduced market spending resulting in serious financial impacts for the companies, which began to fold one after the other. The dotcom bubble burst in March 10, 2000 after the NASDAQ composite index reached 5048.62, more than double its value a year before (Rapp, 2009:175). This was because of increase of interest rates six-folds by the US Federal Reserve, making the economy lose its growth speed. The NASDAQ fell significantly, but was saved from total collapse by market analysts. Part of the trigger came from adverse fact-findings in a case by the US government against Microsoft. The care report declared Microsoft a monopoly and in April 4, 2000, the composite index at NASDAQ fell to 3649 then back to 4223. An article in March 20, 2000 claimed that the 371 publicly traded dotcom companies had significantly grown such that their combined value was more than 1.3 trillion dollars, about 8% of the US stock market at that time (Melamed, 2009:72). Major issues in the dotcom bubble were outside factors like outsourcing, which led to unemployment for computer programmers and developers. The terrorist attack in 2001 in the United States also had a major downturn in the market. The most recent market crush was in the subprime mortgages and collateral debt obligation (CDO) in the late 2000s, which was characterized by abnormal rise of mortgage foreclosures and delinquencies, and the consequent decline in the securities that were backed by these mortgages. Initially, the rate of low-quality subprime mortgages was approximately 8% in the period before 2004, but this figure rose to 20% between 2004 and 2006 (Kolb, 2010:242). In addition, over 90% of these mortgages at that period were adjustable-rate. These were the main factors that led to high-risk mortgage and low lending standards of financial institutions. In addition, individual households were becoming heavily indebted, emphasis on mortgage-related debts, with the debts to disposable personal income of 77% in 1990 rising to 127% in 2007 (Rapp, 2009:222). Refinancing of the then rising house prices in 2006 became difficult resulting to high mortgage delinquencies as the adjustable-rate mortgage reset high interest rates. Mortgage-backed securities, particularly subprime mortgages, held by firms and financial institutions significantly lost their value. Investors throughout the world reduced their purchase of mortgage-based securities and debts in their efforts to reduce lending. Arguably, the US financial and credit market was in a crisis, and this led to implementation of strict credit policies that caused a decline in economic growth in the US, and Europe alike. The main factor that led to the crisis was the US housing bubble burst that occurred in 2005-2006. The burst was followed by a high rate of defaulters on adjustable rate mortgages and subprime debts. Fraud in the mortgage market and economic incentives increased the number of subprime mortgages available to individuals who would have otherwise not qualified for them. The rise of interest rates on the mortgages in 200-2007 made refinancing difficult leading to foreclosures as the prices of houses failed to increase according to the initial speculation (Kolb, 2010:261). To make the situation worse, foreign money was flooding the US from oil-producing countries and Asian nations significantly contributing to the housing and credit bubble. Various types of loans (like credit cards, mortgages, and auto) were easily obtained with the assumption of unprecedented debt burden. In the housing sector, the housing and credit boom resulted in the increase in financial agreements referred to as mortgage-backed securities, whose main value was from the housing prices and mortgage payments. The decline in housing prices led to significant losses in financial institutions that had invested heavily on mortgage-backed securities. The impact of the crisis was the loss of a quarter of America’s net worth. The home equity at the peak of the boom was 13 trillion dollars in 2006, dropping to 8.8 trillion dollars in mid-2008 (Kolb, 2010:289). Retirement assets dropped 8 trillion dollars from 10.3 trillion dollars, with the auto industry suffering the most devastating effects, falling to 12 million from the initial 17 million in 2005. In general, approximately 8.3 trillion dollars was lost in the crisis (Rapp, 2009:237). The primary causes of the crisis were predatory lending, resetting of adjustable-rate mortgages, speculation, and borrower overextending. In all the four market bubbles, one factor is common: speculation. In the 17th century Tulip-mania case, the speculation of tulip bulbs price increment lured many tulip fanciers and professional tulip traders to invest in the market. The involved parties created a limited supply of the bulbs in the market, creating a demand deficit. This automatically raised the prices of the tulips, which led to the consequent burst of the market. The Great Depression of 1929 was, in one way or another, the failure of the Federal government to control the rapidly growing stocks market, combined with the speculative euphoria and the boom psychology of the 1920s in the economy of the US. The credit system in the then financial market also contributed to the financial crisis (Kolb, 2010:123). It is the most significant financial crisis in the Western world that began in the US and spread through Europe to the rest of the world. The dotcom market bubble of the late 1990s originated from fad and speculative investment, easily available capital funding, and the short-term non-profitability of the market venture. Most of the market investors overlooked the price-to-earning ratio of their investments, lured by the speculation that the market would grow enormously. The recent subprime mortgage and collateral debt obligation was fueled by poor credit legislation in the US credit and financial market like predatory lending and borrower extending, and speculation, securitization, and the impacts of adjustable-rate mortgages. Bibliography Galbraith, J. K. 2009. The Great Crash of 1929. New York: Houghton Mifflin Harcourt Publishing Company. Goldgar, A. 2007. Tulipmania:Money, Honor, and knowledge in the Dutch Golden Age. London: University of Chicago Press. Kolb, R. 2010. Lessons From the Financial Crisis: Causes, Consequences, and our Economic Future. New Jersey: John Wiley and Sons Inc. Melamed, L. 2009. For Crying Out Loud: From Open cry to the Electronic Screen. New Jersey: John Wiley and Sons Inc. Rapp, D. A. 2009. Bubbles, Booms, and Busts: The Rise and Fall of Financial Assets. New York: Springer. Read More