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Presenting Empirical Evidence Of The Existence Of "Greater Fools"
With Geoffrey Batt
This weekend the New York Times has published an interesting observation of gender differences when quanitfying the intangible concept of "overconfidence" as it relates to stock trading. While the article throws a relatively minor wrench at the spoke of "efficient markets", we are following it up with a scientific paper by Wei Xiong and Jialin Yu, discussing the Chinese Warrant Bubble, in which speculative mania gripped the trading of warrants so deep out of the money that they were certifiably worthless, yet trading at an increasing turnover rate, and substantially inflated prices. With numerous unequivocal examples of bubbles in the history of capital markets, starting with Dutch tulip mania (1634-37), progressing through the Mississippi bubble (1719-20) the South Sea bubble (1720), the Internet bubble in the late 1990s, and the housing bubbles of the mid 2000s, it appears that human traders never learn from history as the speculative element overpowers rationality each and every time. The underlying premise: the hope that another greater fool will emerge. And emerge they do, until they don't, and markets collapse bidless. It is certainly easy to draw a parallel between the Chinese Warrant Bubble, and the trading of AIG, C, FNM, FRE and a whole slew of otherwise worthless companies, which on occasion make up over 30% of of the volume of the US stock market, which in turn drives the momentum that pushes the balance of all stocks. Another parallel: the entire US stock market is now one big "greater fool" trap waiting to spring once the greater fools have their fill of gambling fever.
As the authors point out:
In 2005-08, over a dozen put warrants traded in China went so deep out of the money that they were certain to expire worthless. Nonetheless, each warrant was traded nearly three times each day at substantially inflated prices. This bubble is unique, because the underlying stock prices make the zero warrant fundamentals publicly observable. We find evidence supporting the resale option theory of bubbles: investors overpay for a warrant hoping to resell it at an even higher price to a greater fool. Our study confirms key findings of the experimental bubble literature and provides useful implications for market development.
The explanation: overconfident, under-informed "speculators" i.e., the bulk of traders in US stock markets, who get the bulk of their finance education from CNBC, who do no homework, yet hope the a stock will be flippable in one second at a higher price, just like a hose was flippable 4 years ago to some other stupid schmuck. We all know how that one ended. We all know how this one will end too. Furthermore, in China, where natural curbs on shorting exist, it shifts the bias even further toward one of optimism, as the "threat" of going into a shorted trade, makes one overly confident that the next natural trade is a buy. This merely goes tho who how any form of shorting curbs simply tend to exaggerate an upward bias to the market in the short-term, yet one which without fail compensates by a more substantial drop in the medium- and long-term.
Unable to short sell, it is natural for a smart investor to speculate on selling an overvalued warrant at an even higher price to another buyer in the future. Without knowing his own limitation in warrant trading (or in other words, by being overconfident), a less sophisticated investor could also have a similar speculative motive, i.e., he buys a warrant aiming to resell it at a higher price later. In such an environment, warrant prices are determined by investors’ speculative motives instead of the underlying stock prices. Even when a warrant is deep out of the money, investors still trade it as long as its price fluctuates, which may be viewed as profit opportunities by these investors.
The authors then go to debunk the fallacy of the fast/smart money hypothesis, identifying it for what it is: early momentum driven speculators who successfully feed off of other less sophisticated speculators.
A large volume of behavioral finance studies suggests that various behavioral biases can lead inexperienced individual investors to feedback positively to past returns. Does this feedback effect exist in the warrants market? Examining the feedback effect can help us understand the time-series dynamics of the warrants bubble...The presence of positive responses of both warrant returns and turnover changes to past warrant returns again highlights the importance of incorporating investor heterogeneity in understanding the warrants bubble, consistent with the key insight of our earlier analysis.
Yet even if greater fools are sufficient, they are certainly necessary: where did they come from in such volumes as to make a difference?
What explains the lack of investor learning in the Chinese warrants market? It turns out that there was a steady flow of new investors attracted into the Chinese financial markets by the stock market boom. According to a recent report by the CSRC (2008), the total number of individual brokerage accounts in China had increased from 80 million to 140 million from 2005 to 2007. It is conceivable that many of these new investors had been trading warrants. While we do not have access to account-level data, a recent study by Pan, Shi and Song (2008) analyzes all the accounts involved in trading one warrant issued by the BaoGang Cooperation and find that the flow of new investors had a positive impact on the warrant price. The large inflow of inexperienced investors is common during the booming periods of many developed and emerging financial markets. Since most experimental studies focus on a given set of subjects, they tend to miss the important effects of the endogenous inflow of inexperienced investors on bubbles.
And the key caution the authors derive is one that is all too applicable for the US in its current comparable frenzied bubble state:
The Chinese government introduced warrants with the aspiration that they can provide a tool for the Chinese investors to hedge stock price risk in a market environment with many existing restrictions on trading stocks, such as prohibition on short-selling and margin buying. To facilitate this objective, the Chinese government has enacted several rules (the T+0 rule, no stamp tax and registration fee, and wider daily price change limit) to make trading warrants much more convenient than trading stocks. This effort failed to achieve its intended effect. Instead, it led to a spectacular bubble. This outcome might appear surprising. However, it could be explained by a widely documented psychological bias---illusion of control, i.e., people behave as if their personal involvement can influence the outcome of random events (Langer, 1975 and Presson and Benassi, 1996). This bias implies that investors are likely to confuse the control they have---over trading the warrants quickly and cheaply---with the control they lack---over the return the warrants might realize. The frenzied trading and spectacular bubble occurred in the Chinese warrants market thus caution future governments regarding granting too much trading capacity to (possibly inexperienced) investors at an early stage of market development.
With ever-dropping volumes and a shift away from institutional trading, is it precisely the inexperienced marginal traders: the retail and the Ph.D written algo signal models, that determine the price level of the S&P? If so, watch out below when this brand new bubble pops, as bubbles eventually always tend to do.
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Apparently then the greatest fool is the US government with taxpayers money. Today reminds me of the near bankrupting of CA by then guv Grey Davis. He bought massive amounts of energy futures during record high prices. I guess governments never learn either.
http://books.google.com/books?id=13hQsRIEM5IC&dq=theory+of+crowds+french...
As the authors present, nothing new under the sun here in studying these warrants. The tradeable markets are intentionally set up as auction markets to encourage speculation & price chasing, either up or down. The herd will follow the trend in prices until the last buyer buys or the last seller sells.
Figure 1 is an excellent example of a parabola fitting the contours of the Fibonacci spiral. An up move followed by a long curved middle period, then the up move begins & accelerates into the parabola which climbs almost vertically til it almost literally crests over itself, followed by a partial collapse & final up move that can't reach the parabola high.
Figure 4 is reminiscent of our VIX chart in a much smaller time frame thus showing the fractals that can occur in longer or smaller periods are the same. Markets move in fractal geometry, not in a linear fashion.
I won't argue that people don't do stupid things with money (20" chrome rims for example), but some mania behavior may stem from the idea that a person can 'save' work, in whatever form it might be, for later use.
20" rims!? Pffff. I'm rollin' on 22s, yo.
Who's da bigga foo now, playa?
I sure hope you are!
But how will the US markets ever collapse when the Freasury(or Tred) will perpetually volunteer US taxpayer fiatscos in the perpetual greater fool bid? And no I have no idea what I'm talking about, please enlighten me.
The stock market does not exist in a vacuum. If the Treasury and Fed does decide that the market can never go down again then that lose will be taken out of the value dollar. The dollar would lose purchasing power just as the market was maintaining or gaining in notational value measured in now devalued dollars. There is no free lunch.
Don't you think that The PE ratios will skyrocket and expose the (%) of inflation expectation or real inflation?
From the Times article:
“There’s been a lot of academic research suggesting that men think they know what they’re doing, even when they really don’t know what they’re doing...”
I get the whole "men refuse to stop and ask for directions" bit, but did you see Charlize Theron at the Oscars!?
Also from the Times article:
"The latest data comes from Vanguard, the mutual fund company. Among 2.7 million people with I.R.A.’s at the company, it found that during the financial crisis of 2008 and 2009, men were much more likely than women to sell their shares at stock market lows. Those sales presumably meant big losses — and missing the start of the market rally that began a year ago."
That's not necessarily a true composite of trading activity. It doesn't account for the number of men who's wives won't give it up until they unloaded their holdings (no pun intended).
but this time it's different.
It's always different THIS time!
The Austrians beat them to this as well. From Doug French, 1992, UNLV:
http://www.pdfdownload.org/pdf2html/pdf2html.php?url=http%3A%2F%2Fmises....
Worth the read if you're looking to understand the causes of historical booms and busts.
If the stock market does roll over then there will be one significant difference compared to the internet and housing bubble pops.
With the internet and housing bubbles it was individual members of the public who were the marginals buyers at the very top - the 'greatest fools' so to speak.
As I understand things individual members of the public have basically been out of the stock market rally since the lows of last March (ain't got no money and having been burned by tech, 2008 and housing) and have instead been withdrawing from mutual funds and moving into bonds (which are there own bubble). The general public has no confidence in the stock market rally.
If the stock market does rolls over then for the first time in a long-while it won't be the public that are the biggest chumps.
Given that the general public are never ever ever the winners this is additional evidence that it will be the bond market rather than the stock-market that will roll over.
And now this, courtesy of the greater fools in the US Congress:
http://news.yahoo.com/s/ap/us_social_security_ious
Control, influence and those who understand the differences.
master bates comes to mind lol
Funny how the word endogenous is employed but once when the entire premise of the issue (unbeknownst) to the NYT n 'research' authors is just that - endogenously regulated social mood.
Direct foreign investment into the China in 2009:
Banking + 115%
RE + ~ 90%
Total (includes the above and all other industries) - 14%
http://www.stats.gov.cn/english/
The rates staying low for an extending period of time is a preample for the next bubble to show up 3 years from now.
time123
admin http://invetrics.com/?tag=invetrics-calls-the-bottom
I love the site and all, but please don't describe economics as a science. It's a load of more-or-less plausible sounding speculation from oversimplified first principles, loosely buttressed by a few stray empirical observations.
The fact that the empirical approach of behavioural econ was seen as some radical departure just proves that the discipline is three hundred years behind the rest of the intellectual world.
(I have an econ degree, to pre-empt the inevitable responses)
Bullish USD weekly chart continues and DOW/SP500/EURO daily chart give bearish warnings.
http://www.zerohedge.com/forum/market-outlook-0
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