63 𝑅𝐸𝑇 = −0.0206 = −𝟐. 𝟎𝟔 %
The actual returns following the burst of the Dot-com bubble were very close the forecasted returns above and proved to be very poor in the following years (Siegel, 2016). The Dot-com bubble stands out as a very valuable and clear example of the usefulness of the CAPE ratio as a tool of identifying bubble situations based on deviations in prices from fundamental value of stocks.
On the other hand, there is not a clear consensus between EMH proponents, as to what happened in the late 1990’s and if it could even be characterized as a bubble. Some argue that hindsight bias plays a central part in discrediting the theory of efficient markets (Malkiel, 2003). Furthermore, as previously mentioned, it was argued that even though a bubble could be identified, it was not certain that arbitrage opportunities existed.
64 The hard assumption of rational expectations in the financial markets, seems to have played out its role in explaining the behavior of stock markets and the business cycle. The overconfidence in the rationality and efficiency of markets per RBC theory and EMH has proven not to be the best solution. There is a clear need for adjustments to expectation modelling, in order to properly mimic the actual behavior of human beings, corporations and economies. Some would maybe argue that markets become more efficient after each bubble and financial crisis, as investors and market actors learn from their mistakes.
However, it is very important to not underestimate the cognitive biases at work, and how everything looks clearer in hindsight. Furthermore, it is dangerous to believe that today is different, as expressed by Reinhart & Rogoff:
“The essence of the this-time-is-different syndrome is simple. It is rooted in the firmly held belief that financial crises are things that happen to other people in other countries at other times; crises do not happen to us, here and now … The old rules of
valuation no longer apply. The current boom […] is built on sound fundamentals, structural reforms, technological innovation, and good policy. Or so the story goes.”
(Reinhart & Rogoff, 2009, p. 15)
On the other hand, the paradigm shifts in finance and economics caused by stock bubbles are intriguing and we have probably not seen the last of it. The latest paradigm shift has been the appearance of behavioral finance, and this branch of economics is undoubtedly here to stay. Behavioral finance provides the “missing link” between ideas, such as animal spirits and financial fragility, and the prevailing economic models and theories.
For now, it seems that we must still be cautious of the tendency of stock markets to exhibit bubble behavior. This thesis argues that fundamental analysis and specifically fundamental ratios such as CAPE, P/B and D/P must play a central role in the identification of possible bubbles. Although there exist no better alternatives to predicting future stock returns and identifying bubble situations, the literature written about CAPE and other fundamental ratios is quite sparse. This especially the case with regards to markets other than the S&P 500. This thesis recommends further researching some of the following questions:
65
Is a ten-year average of earnings the best fit for the CAPE model, or would another number of years in the moving average prove a better regression fit?
Why does Canada not fit any of the fundamental ratios?
Why does the Danish and Swedish stock markets produce such high returns despite high CAPE ratios?
At the time of writing, the CAPE of the S&P 500 was 26.59 in October 2016, which is 59% above its all-time mean of 16.71. This indicates that prices are deviating significantly from their fundamental value. As discussed in chapter 4.1.4, there are some arguments in very recent research (Siegel, 2016) for an upward shift of the natural level from the long-term mean and this would make it more difficult to determine how much the prices are deviating from their fundamental value. This paper recommends further research on the subject, in order to more accurately determine the possibility of whether or not a new bubble in the stock markets are underway.
As discussed earlier, Minsky’s financial instability hypothesis offers some useful recommendations for policymakers. Not only central bankers have the power to regulate against stock bubbles with monetary policy tools, but also governments play a role with financial regulations. With the advent of quantitative easing and very low (sometimes negative) interest rates in many developed countries, it remains to be seen what effect this will have on the credit cycle and the fragility of the financial system.
6 Conclusion
Bubbles in the stock market are complicated phenomena. This literature review has presented a wide range of relevant theoretical perspectives on the identification and control of stock bubbles. Although there have been proposed many different definitions of bubbles throughout the years, most agree on the trait of a divergence between fundamental value and observed price. The concept of fundamental value constitutes the backbone of the field of finance within economics, and it is thus very appropriate that fundamentals of stocks forms the theoretical anchor for analysis of bubbles.
The review of theories pertaining to business cycles in chapter 3, shows that many different interpretations of the relationship between business cycles and stock bubbles exist. However, effects go
66 both ways and it is largely impossible to view stock bubbles as economic phenomena in a vacuum separated from the broader macroeconomic landscape. It can be argued that Keynes, ABCT, Schumpeter and Minsky all provide useful interpretations of stock bubbles, but it is clear that none of the discussed theories and models can stand alone, due to the inherent complexity and multitude of effects and relationships observed.
According to this review, the best available tool for stock bubble identification is fundamental ratio analysis, including CAPE, CAPEadj, P/B, D/P and P/C, of stock market indices. These fundamental ratios are empirically proven to be meaningful predictors of subsequent ten-year returns. The CAPE ratio is established to be the best tool for most markets, but some countries display more accurate results with the other ratios, while the Canadian stock market is an anomaly. Further research is needed to address the identified irregularities and whether reversion towards long-term means (i.e. natural levels) is realistic in the light of accounting changes and other changing factors. With the challenges to the EMH and RBC theory, it seems that behavioral finance will have play a bigger role in future financial models. Behavioral finance theories can help bring understanding to how markets work, and how investors make their decisions in practice. Hopefully, this will also help investors reduce their unintelligent speculation.
Following the subprime mortgage crisis, there seems to have been a shift in opinion in favor of controlling asset bubbles (including stock bubbles). Apparently, policy makers are taking a more proactive approach to asset price bubbles, than they have before. Hindsight bias is very prevalent when discussing bubbles, but there are still strong arguments that central bankers and governments did not do enough to prevent the Dot-com bubble and the subprime meltdown. Monetary policy and financial regulations remain the two primary tools for controlling stock bubbles, and Minsky’s model remains relevant for structuring how the financial system works.
Looking ahead, the study and examination of stock bubbles remains as important as it has ever been.
Throughout history the stock markets of the world have continuously proven to be inefficient and irrational at times (at least on an aggregate level) and no one can predict with certainty what the next chapter of economic and financial history will bring. The thesis has shown that different heuristic tools for identification and control of bubbles are available for central bankers, governments and investors.
However, we acknowledge that the full objective truth of stock bubbles cannot fully be maintained as it
67 is a very complex phenomenon. But, the search for explanations of stock bubbles has consistently helped evolve and advance the science of economics and this will hopefully continue in the future.
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