bubbles crashes slides

8/6/2019 Bubbles Crashes Slides

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Bubbles and Crashes

Dilip AbreuPrinceton University

Markus K. BrunnermeierPrinceton University

Hedge Funds and

the Technology Bubble

Markus K. Brunnermeier

Princeton University

Stefan Nagel

London Business School


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Company X introduced a revolutionary wirelesscommunication technology.

It notonly provided support for such a technology but also

providedthe informational content itself.Its IPO price was $1.50 per share. Six years later it wastraded at $ 85.50 and in the seventh year it hit $ 114.00.

The P/E ratio got as high as 73.

The company never paiddividends.

Story of a typical technology stock

About RCA: READ Bernheim et al. (1935)The Security Market Findings and

Recommendations of a special staff of the 20th century fund - p. 475 and following


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Story of RCA - 1920s

Company: Radio Corporation of America (RCA)

Technolgoy: Radio

Year: 1920s

Itpeake

d

at$ 397 in Feb. 1929,

do

wnto

$ 2.62 in May 1932,

1

1

2

2

3

3

time

$

Dec 25 Dec 50

(was < $ 14 till June 1945)


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Internet bubble? - 1990sNASDAQ Combined Composite Index NEMAX All Share Index (German Neuer Markt)

38 day average

Chart (Jan. 98 - Dec. 00)

38 day average

Chart (Jan. 98 - Dec. 00) in Euro

Loss ofca. 60 %

from high of$ 5,132

Loss ofca. 85 %85 %

from high ofEuro 8,583

Why do bubbles persist?

Do professional traders ride the bubble or

attack the bubble (go short)?

What happened in March 2000?

Was it a bubble?

If it was a bubble, the question arises

Moving right along to the 1990s


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Do (rational) professional ride the bubble?

South Sea Bubble (1710 - 1720)Isaac Newton

04/20/1720 sold shares at 7,000 profiting 3,500

re-enteredthe market later - ended up losing 20,000

I can calculate the motions ofthe heavenly bodies, butnotthe madness of people

Internet Bubble (1992 - 2000)

DruckenmillerofSoros Quantum Funddidntthink

thatthe party would end so quickly.We thought it was the eighth inning, and it was the ninth.

Julian Robertson of Tiger Fund refusedto invest ininternet stocks


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The moral ofthis story is that irrational marketcan kill you

Julian said This is irrational and I wont play and

they carried

himout feet first.

Druckenmiller said This is irrational and I will playandthey carried him out feet first.

Quote of a financial analyst, New York TimesApril, 29 2000

Pros dilemma


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Classical Question

Suppose behavioral trading leads to mispricing.Suppose behavioral trading leads to mispricing.

Can mispricings or bubbles persist in thepresence of rational arbitrageurs?

Whattype of information can leadtothebursting of bubbles?


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Main Literature

Keynes (1936) bubble can emergebubble can emergeIt might have been supposedthatcompetition between expert professionals,possessing judgment and knowledge beyondthatofthe average privateinvestor, would correctthe vagaries ofthe ignorant individual leftto himself.

Friedman (1953), Fama (1965)Efficient Market Hypothesis no bubbles emergeno bubbles emerge

Ifthere are many sophisticatedtraders in the market, they may cause thesebubbles to burst before they really get under way.

Limits to ArbitrageNoise trader risk versus Synchronization risk

Shleifer & Vishny (1997), DSSW (1990 a & b)Bubble Literature

Symmetric information - Santos & Woodford (1997)

Asymmetric information

Tirole (1982), Allen et al. (1993), Allen & Gorton (1993)


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Timing Game - Synchronization

(When) will behavioral traders beoverwhelmed by rational arbitrageurs?

Collective selling pressure of arbitrageurs

more than suffices to burstthe bubble.Rational arbitrageurs understandthat aneventualcollapse is inevitable.

But when?Delicate, difficult, dangerous TIMING GAME!


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Elements of the Timing Game

Coordination at least > 0 arbs have to be outofthe market

Competition only first < 1 arbs receive pre-crash price.

Profitable ride ride bubble (stay in the market) as long as possible.

Sequential Awareness

A Synchronization Problem arises!Absentof sequential awareness

competitive elementdominates and bubble burst immediately.With sequential awarenessincentive to TIME THE MARKET leads to delayed arbitrage and

persistence of bubble.


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model setup

introduction

preliminary analysis

persistence ofbubbles

public events

conclusion

price cascades and rebounds


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Model setup

tt

0 t0+t0+

randomstarting

point

t0+

maximum life-span ofthe bubble

tradersare aware ofthe bubble

all tradersare aware ofthe bubble

bubble burstsfor exogenous

reasons

0

paradigm shift

- internet 90s

- railways- etc.

common action of arbitrageurssequential awareness(random t0 with F(t0) = 1 - exp{-t0}).

1

1/

pt


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Payoff structure

Cash Payoffs (difference)Sell one share att- insteadof att.

pt- er - pt

wherept=

Execution price atthe time of bursting.

prior to the crash

after the crash

forfirst random orders up to

all otherorders


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Payoff structure (ctd.), Trading

Small transactions c

osts ce

rt

Risk-neutrality but max/min stock position

max long position

max short position

due to capital constraints, margin requirements etc.

Definition 1: trading equilibrium

Perfect Bayesian Nash Equilibrium

Belief restriction: trader who attacks attime tbelieves that all traders who became aware ofthebubble priorto her also attack att.

Definition 1:


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introduction


public events

conclusion


model setup

Preliminary analysis

preemption motive - trigger strategies

sell out condition


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TriggerStrategies

Bursting date T*(t0

)=min{T(t0

+), t0

+ }

Role of Preemption Motive

Rules out coordinated sell outon Friday July 13th.

Bubble never bursts with strictly positive prob. at some t13.

Suppose it w

ould, then selling pressure w

ould

exceed

with prob>0.

Hence, price woulddrop already att13 incentive to sell out earlier

well defineddensity of bursting date (t|ti) for each arb.

Proposition 1: Trigger strategies.

Given c > 0, arb tinever sells outonly for an instant.He stays outofthe market at least until ti+ sells out.

Arb ti+ stays out until ti+ 2 exits and soon.

By trading equilibrium, arb ti stays out until ti+ exits.also illustrates failure ofstrategic complementarity

(pre-empt)

iftraders condition on calendar time

Proposition 1:


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Sell out condition for periods

sell out attif

r i tio r te

benefit of ttacking cost ofattacking

RHSconverges to [(g-r)] as t

bursting date T*(t0)=min{T(t0+), t0+ }

h(t|ti)Et[bubble|] (1-h(t|ti) (g- r)pt


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introduction


public events

conclusi

on


model setup

persistence of bubbles

exogenous crashes

endogenous crashes

lack of common knowledge


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Persistence of Bubbles

Proposition 1: Suppose .

existence of a unique trading equilibrium

traders begin attacking after a

delay

ofperiods.

bubble does notburstdue to endogenous sellingpriorto .

Proposition 2:


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Sequential awareness

t

traderti

ti-

since ti t0+

Distribution oft0

t0 t0+

since ti t0

ti

tk

Distribution oft0+

(bursting of bubble if nobody attacks)

t

tradertjtjtj-

t

tradertk

_


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Conjecture 1: Immediate attack

Bubble bursts at t0+

when traders are aware ofthe bubble

Ift0< ti- , the bubble

would have burst already.

/(1-e-)

Distribution oft0

Distribution oft0+

tti- ti- ti+ti


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Conj. 1 (ctd.): Immediate attack

t


Distribution oft0+

Bubble burstsfor sure!

hazard rate ofthe bubbleh = /(1-exp{-(ti+ -t)})

/(1-e

-

)

ti- ti- ti+ti

Distribution oft0


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Conj. 1 (ctd.): Immediate attack

t


Bubble burstsfor sure!

hazard rate ofthe bubbleh = /(1-exp{-(ti+ - t)})

/(1-e

-

)

ti- ti- ti+ti

Distribution oft0

optimal time

to

attack ti+

i

delayed attack is optimaldelayed attack is optimalno immediate attack equilibrium!no immediate attack equilibrium!

bubble appreciation / bubble size

Recall the sell out condition:

_lower bound: (g-r)/ >/(1-e-)


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t

hazard rate ofthe bubbleh = /(1-exp{-(ti+ + -t)})

ti- ti

Conj. 2: Delayed attack by arbitrary

Bubble bursts at t0 + + < t0 +

ti- + + ti+ +ti+

optimal todelayattack even moreeven more

conjecturedattack

attack is never successfulattack is never successful bubble bursts for exogenous reasons atbubble bursts for exogenous reasons at t0 +

lower bound: (g-r)/ >/(1-e-)

bubble appreciationbubble size

/(1-e-)

_

_

_


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Endogenous crashes

Proposition 3: Suppose .unique trading equilibrium.

traders begin attacking after a delay of* periods.

bubble bursts due to endogenous selling pressureat a size ofpt times

Proposition 3:

arbitrageurs eventuallyburst bubblebut very late

(bridgebetween traditional analysis and Proposition 1)


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Endogenous crashes

t

hazard rate ofthe bubbleh = /(1-exp{-(ti+ + - t)})

ti- ti- ti

lower bound: (g-r)/ >/(1-e-)

Bubble bursts at t0+ +*

ti- + +**ti++**ti+**

optimal

conjecturedattack

bubble appreciation

bubble size

_


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Endogenous crashes - deriving *

In equilibrium traderti= t0+

bursts the bubble.

When she sells his shares her supportoft0 is [ti- , ti],hence his hazard rate is h = /(1-exp{-})

(1)

The bubble bursts atti= t0+ +*,hence it bursts at a size of egt*(*)bubble appreciation/ size = (g-r+z) / *(*) (2)

equilibriumh

(1)

bubble appreciationbubble size

(2)

*


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Comparative statics

Role of information dispersion , Priordistribution oft0 F(t0) = 1 - exp{-t0}

the smaller, the larger*, the size of bubble

t0= 0, no infodispersion no bubble 0 distributions uniform [size is (g-r) ]

Dispersion ofopinion

as bubbles size

for exogenous crash

Role of momentum traders same as for More synchronization required More synchronization required


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Lack of common knowledge

t0 t0+

standard backwards induction cant be appliedstandard backwards induction cant be applied

t0+everybody

knows ofthethe bubble

traders

know ofthe bubble

everybody knows thateverybody knows ofthe

bubble

t0+ 2 t0+ 3

everybody knows that

everybody knows thateverybody knows of

the bubble

(same reasoning applies for traders)

Ifone interprets as difference in opinion,lack of common knowledge gets a different meaning too.


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introduction



conclusion


synchronizing events

model setup


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Role of synchronizing events (information)

News may have an impactdisproportionateto any intrinsic informational (fundamental)content.

News can serve as a synchronization device.

Fads & fashion in information

Which news shouldtraders coordinate on?

When synchronized attack fails, the bubbleis temporarily strengthened.


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Setting with synchronizing events

Focus on news with no informational content(sunspots)

Synchronizing events occur with Poisson arrivalrate .

Note thatthe pre-emption argumentdoes not apply sinceeventoccurs with zero probability.

Arbitrageurs who are aware ofthe bubble becomeincreasingly worried about itovertime.

Only traders who became aware ofthe bubble more thane periods agoobserve (look out for) this synchronizingevent.


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Synchronizing events - Market rebounds

Proposition 5: In responsive equilibriumSell out a) always atthe time of a public eventte,

b) afterti+** (where **te - e -

without public event, they would have learntthisonly atte + e - **.

the existence of bubble attreveals thatt0>t- ** -

that is, no additional information is revealedtill te - e +**

density that bubble bursts for endogenous reasons is zero.

Proposition 5:


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introduction



public events

conclusion

model setup

price cascades andrebounds


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Price cascades and rebounds

Price drop as a synchronizing event.through psychological resistance line

by more than, say 5 %

Exogenous price dropafter a price drop

if bubble is ripe bubble bursts and price drops further.

if bubble is not ripe yet price bounces back andthe bubble is

strengthened for some time.


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Price cascades and rebounds (ctd.)

Proposition 6:Sell out a) after a price drop ifip(Hp)

b) afterti+*** (where ***


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Conclusion of Bubbles and Crashes

Bubbles

Dispersion ofopinion among arbitrageurs causes asynchronization problem which makes coordinatedprice corrections difficult.

Arbitrageurs time the market and ride the bubble.

Bubbles persist

Crashes

can be triggered by unanticipated news without anyfundamental content, since

it might serve as a synchronization device.

Rebound

can occur after a failed attack, which temporarily

strengthens the bubble.

(technological revolutions etc.)


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Hedge Funds andthe Technology Bubble

Markus K. BrunnermeierPrinceton University

Stefan NagelLondon Business School

http://www.princeton.edu/~markus


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reasons for persistence

data

empirical results

conclusion


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1. Unawareness of Bubble Rational speculators perform as badly as others when market collapses.

2. Limits to ArbitrageFundamental risk

Noise trader riskSynchronization risk

Short-sale constraint

Rational speculators may be reluctant to go shortoverpriced stocks.

3. Predictable InvestorSentimentAB (2003), DSSW (JF 1990)

Rational speculators may wanttogo longoverpriced stock and

try to go short priorto collapse.

Why Did Rational Speculation Fail toPreventthe Bubble ?

About RCA: READ Bernheim et al. (1935)The Security Market Findings and

Recommendations of a special staff of the 20th century fund - p. 475 and following


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data


empirical results

conclusion


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Data

Hedge fund stock holdings

Quarterly 13 F filings toSEC

mandatory for all institutional investorswith holdings in U.S. stocks of more than $ 100 million

domestic and foreign

at manager level

Caveats: No short positions

53 managers with CDA/Spectrum data

excludes 18 managers b/c mutual business dominates

incl. Soros, Tiger, Tudor, D.E. Shaw etc.

Hedge fund performance data

HFR hedge fund style indexes


43


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data

co

nclusio

n


empirical results

did hedge funds ride bubble?

did hedge fundstiming pay off?


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Fig. 4a: eight of technology stoc s in hedge fund ortfolios versus eight in

ar et ortfolio

0.00

0.20

0.40

0.60

0.80

Mar-98 Jun-98 Sep-98 Dec-98 Mar-99 Jun-99 Sep-99 Dec-99 Mar-00 Jun-00 Sep-00 Dec-00

Proportion invested in NA DA high P/S stocks

Zw e ig- DiMenna

Soros

Hus ic

Market Portfolio

OmegaTiger

Did Sorosetc. ride thebubble?

46


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Fig. 4b: Funds flo s, three- onth oving average

-0.20

-0.

-0. 0

-0.05

0.00

0.05

0. 0

Mar- 98 Jun-9 8 Sep-98 Dec-98 Mar- 99 Jun-9 9 S ep-99 Dec-99 Mar- 00 Jun-00 Sep-00 Dec-00

Fund flow sasproportionofassetsunder anagem ent

Quantu und (Soros)

Jaguar und (Tiger)

Fund in- andoutflows

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0.00

0.10

0.20

0.30

0.40

0.50

0.60

-4 -3 -2 -1 0 1 2 3 4

Quarters around Price Peak

High P/S NASDAQ Other NASDAQ NYSE/AMEX

Share of equity held (in %)

Figure 5. Average share of outstanding equity held by hedge funds around rice ea s

of individual stoc s

Did hedge funds time stocks?

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Figure 6: Performance of a copycat fund that replicates hedge fund holdings in the

ASDAQ high P/S segment

Mar-98 Jun-98 Sep-98 Dec-98 Mar-99 Jun-99 Sep-99 Dec-99 Mar-00 Jun-00 Sep-00 Dec-00

Total return index

High /S Copycat und All High /S ASDAQStocks

.0

2.0

3.0

4.0

Did hedge funds timing pay off?

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Conclusion

Hed

ge fund

s were rid

ing the bubbleShort sales constraints and arbitrage riskare not sufficientto explain this behavior.

Timing bets of hedge funds were well

placed. Outperformance!Rules out unawareness of bubble.

Suggests predictable investor sentiment.

Riding the bubble for a while may havebeen a rational strategy.

Supports bubble-timing models


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