THE STOCK MARKET CRASH OF 2000

AND THE 1990s INTERNET BULL MARKET

[The following text is taken from Malkiel (2003)]

Critics of market efficiency argue that there are several instances of recent market history where market prices could not plausibly have been set by rational investors and that psychological considerations must have played the dominant role. It is alleged, for example, that the stock market lost about one-third of its value from early to mid-October 1987 with essentially no change in the general economic environment. How could market prices be efficient both at the start of October and during the middle of the month? Similarly, it is widely believed that the pricing of Internet stocks in early 2000 could only be explained by the behavior of irrational investors. Do such events make a belief in efficient markets untenable?

The Internet "Bubble" of the late 1990s

Another stock market event often cited by behavioralists as clear evidence of the irrationality of markets is the Internet "bubble" of the late 1990s. Surely, the remarkable market values assigned to Internet and related high-tech companies seem inconsistent with rational valuation. I have some sympathy with behavioralists in this instance, and in reviewing Robert Shiller’s (2000) Irrational Exuberance, I agreed that it was in the high-tech sector of the market that his thesis could be supported. But even here, when we know after the fact that major errors were made, there were certainly no arbitrage opportunities available to rational investors before the "bubble" popped.

Equity valuations rest on uncertain future forecasts. Even if all market participants rationally price common stocks as the present value of all future cash flows expected, it is still possible for excesses to develop. We know now, with the benefit of hindsight, that outlandish and unsupportable claims were being made regarding the growth of the Internet (and the related telecommunications structure needed to support it). We know now that projections for the rates and duration of growth of these "new economy" companies were unsustainable. But remember, sharp-penciled professional investors argued that the valuations of high-tech companies were proper. Many of Wall Street’s most respected security analysts, including those independent of investment banking firms, were recommending Internet stocks to the firm’s institutional and individual clients as being fairly valued. Professional pension fund and mutual fund managers overweighted their portfolios with high-tech stocks.

While it is now clear in retrospect that such professionals were egregiously wrong, there was certainly no obvious arbitrage opportunity available. One could disagree with the projected growth rates of security analysts. But who could be sure, with the use of the Internet for a time doubling every several months, that the extraordinary growth rates that could justify stock valuations were impossible? After all, even Alan Greenspan was singing the praises of the new economy. Nothing is ever as clear in prospect as it is in retrospect. The extent of the "bubble" was only clear in retrospect.

Not only is it almost impossible to judge with confidence what the proper fundamental value is for any security, but potential arbitrageurs face additional risks. Shleifer (2000) has argued that "noise trader risk"—the risk from traders who are attempting to buy into rising markets and sell into declining markets—limits the extent to which one should expect arbitrage to bring prices quickly back to rational values even in the presence of an apparent bubble. Professional arbitrageurs will be loath to sell short a stock they believe is trading at two times its "fundamental" value when it is always possible that some greater fools may be willing to pay three times the stock’s value. Arbitrageurs are quite likely to have short horizons, since even temporary losses may induce their clients to withdraw their money.

While there were no profitable and predictable arbitrage opportunities available during the Internet "bubble," and while stock prices eventually did adjust to levels that more reasonably reflected the likely present value of their cash flows, an argument can be maintained that the asset prices did remain "incorrect" for a period of time. The result was that too much new capital ‘ owed to Internet and related telecommunications companies. Thus, the stock market may well have temporarily failed in its role as an efficient allocator of equity capital. Fortunately, "bubble" periods are the exception rather than the rule, and acceptance of such occasional mistakes is the necessary price of a flexible market system that usually does a very effective job of allocating capital to its most productive uses.

Are there not some illustrations of irrational pricing that can be clearly ascertained as they arise, not simply after a "bubble" has burst? My favorite illustration concerns the spinoff of Palm Pilot from its parent 3Com Corporation during the height of the Internet boom in early 2000. Initially, only 5 percent of the Palm Pilot shares were distributed to the public; the other 95 percent remained on 3Com’s balance sheet. As Palm Pilot began trading, enthusiasm for the shares was so great that the 95 percent of its shares still owned by 3Com had a market value considerably more than the entire market capitalization of 3Com, implying that all the rest of its business had a negative value. Other illustrations involve ticker symbol confusion. Rasches (2001) finds clear evidence of comovement of stocks with similar ticker symbols; for example, the stock of MCI Corporation (ticker symbol MCIC) moves in tandem with an unrelated closed-end bond investment fund Mass Mutual Corporate Investors (ticker symbol MCI). In a charming article entitled "A Rose.com by Any Other Name," Cooper, Dimitrov and Rau (2001) found positive stock price reactions during 1998 and 1999 on corporate name changes when "dot com" was added to the corporate title. [...] But none of these illustrations should shake our faith that exploitable arbitrage opportunities should not exist in an efficient market. The apparent arbitrage in the Palm Pilot case (sell Palm Pilot short and buy 3Com) could not be undertaken because not enough Palm stock was outstanding to make borrowing the stock possible to effectuate a short sale. The "anomaly" disappeared once 3Com spun off more of Palm stock. Moreover, the potential profits from name or ticker symbol confusion are extremely small relative to the transactions costs that would be required to exploit them.

[End]

Blowing bubbles?

As usual, much of the debate about the 1990s increase in stock market prices and subsequent decline is about perceptions of the rational fundamental value of the market. Many commentators point to the historically high valuation measures such as PE ratios. However, these measures depend on fundamental determinants that need not be constant through time (see Wetherilt and Weeken (2002) for a discussion) and can be very misleading for new technology stocks (close to zero or negative earnings).

The very popular long-run Gordon growth model (1-stage DDM) has also frequently been used to show that stock markets significantly exceeded their fundamental values. On the other hand, economists from the Bank of England (Panigirtzoglou and Scammell, 2002) show convincingly that a simple adjustment of the model (i.e. a 3-stage rather than 1-stage dividend growth model) is sufficient to explain stock market valuation in the UK and US during the late-1990s. This study basically shifts the discussion about rational valuation to the rationality of financial analysts' forecasts of (long-term) earnings growth. Economists continue to debate the empirical evidence on rational forecasting in financial markets. A myopic reading of the empirical results suggests that financial analysts are irrational (producing systematically biased forecasts), similar to the conclusion frequently drawn for financial market investors (exaggerating fundamental value). Closer examination of the empirical results suggests, however, that frequently the empirical studies themselves are biased because they insufficiently account for problems in the data used (for example, different concepts of earnings, revisions in historical data) and the estimation methods (inappropriately accounting for correlations in forecast errors) (see for example Kean and Runkle, 1998; Abarbanell and Lehavy, 2003).

Internet technology stocks

The crash of 2000 is related particularly to the bull market in Nasdaq internet technology stocks, or, more generally, the sector of technology, media, and telecommunications. The new technology stocks seem to defy attempts to use normal valuation measures used for seasoned stocks and mature companies. Fundamental to new technology stocks is their inherent option value with respect to future growth and profits - new technology may be extremely successful, but is also likely to fail. Dwyer and Barnhart (2002) examine historical returns on investments in new technology stocks and find that despite the many company failures, average returns to investors are still positive. Pastor and Veronesi (2004) examine the option price effect for Nasdaq stocks and find that although valuations require a high level of uncertainty (i.e. extreme positive possibilities), the required level is not implausible.

Conclusion

Clearly, market prices have undergone a substantial correction in the crash of 2000. To conclude that the crash was an inevitable result of irrational valuations (a "bubble") is very premature and subject to continuing debate.

Literature

• Malkiel, B.G., "The Efficient Market Hypothesis and its critics," Journal of Economic Perspectives, vol.17 (1) Winter 2003: 59-82.
• Panigirtzoglou, N. and R. Scammell, "Analysts' Earnings Forecasts and Equity Valuations". Bank of England Quarterly Bulletin, Spring 2002. Available at SSRN: http://ssrn.com/abstract=708145
• Dwyer, G.P. and C. Barnhart, "Are Stocks in New Industries Like Lottery Tickets?" (August 2002). FRB Atlanta Working Paper No. 2002-15. Available at SSRN: http://ssrn.com/abstract=325820
• Pastor, L. and P. Veronesi, "Was There a Nasdaq Bubble in the Late 1990s?" (December 13, 2004). CRSP Working Paper No. 557; AFA 2005 Philadelphia Meetings Paper. Available at SSRN: http://ssrn.com/abstract=557061
• Keane, M.P. and D.E. Runkle, 'Are financial analysts'' forecasts of corporate profits rational?' Journal of Political Economy, vol.106 (4) 1998: 768-805.
• Abarbanell, J. and R. Lehavy, 'Biased forecasts or biased earnings? The role of reported earnings in explaining apparent bias and over/underreaction in analysts' earnings forecasts,' Journal of Accounting and Economics, vol.36 ( ) 2003: 105-46.
• Vila Wetherilt, A. and O. Weeken, "Equity Valuation Measures: What can they Tell us?" . Bank of England Quarterly Bulletin, Winter 2002 Available at SSRN: http://ssrn.com/abstract=708981

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