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Friday, May 16, 2008

A digest of asset bubbles

 

Bubbles emerge at times when investors profoundly disagree about the significance of a big economic development, such as the birth of the Internet. Because it's so much harder to bet on prices going down than up, the bullish investors dominate.

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Manias can persist even though many smart people suspect a bubble, because no one of them has the firepower to successfully attack it. Only when skeptical investors act simultaneously -- a moment impossible to predict -- does the bubble pop.

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Bubbles don't spring from nowhere. They're usually tied to a development with far-reaching effects: electricity and autos in the 1920s, the Internet in the 1990s, the growth of China and India. At the outset, a surge in the values of related businesses and goods is often justified. But then it detaches from reality.

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One who believes a stock is too high can short it, borrowing shares and selling them in hopes of replacing them when they're cheaper. But this can be costly, both in the fees and in the risk of huge losses if the stock keeps rising. Many big investors rarely short stocks. When differences between bullish investors and bearish ones are extreme, many of the bears simply move to the sidelines. Then, with only optimists playing, prices go higher and higher.

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At some point in a bubble, optimists' enthusiasm runs its course. Prices turn down. There's an expectation that at this point, investors who were skeptical may see prices as more reasonable and start buying. If they don't, that's a signal that prices had gotten way too high -- and then they tumble.

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The insights of bearish investors "are more likely to be flushed out through the trading process when the market is falling, as opposed to when it's rising," Mr. Hong and Harvard's Jeremy Stein write. They say this explains why prices fall more rapidly than they go up. Over 60 years, nine of the 10 biggest one-day percentage moves in the S&P 500 were down.