Making Sense of Irrational Exuberance

By Christopher Farrell Stock market booms and busts are almost as old as the Republic. William Duer, a signer of the Articles of Confederation and a friend of Alexander Hamilton, brought about the first U.S. market crash in 1792. A pool of speculators that Duer organized in late 1791 bet heavily with borrowed money on pushing bank stocks into the stratosphere. The speculative frenzy came to an end when well-heeled adversaries created a credit squeeze and popped the bubble. Duer, by the way, was thrown in debtors' prison, where he died several years later.

London newspaper The Spectator aptly captured America's propensity to gamble, following a U.S. market panic in the late 19th century. "The millionaires of America make corners as if they had nothing to lose. Let some amuse themselves financing as if it were only an expensive game. The English, however speculative, fear poverty. The Frenchman shoots himself to avoid it. The American with a million speculates to win 10, and if he loses takes a clerkship with equanimity. This freedom from sordidness is commendable, but it makes a nation of the most degenerate gamesters in the world."

Bubbles are fascinating, as are tales of fortunes won and lost. But what transforms the normal propensity of "gamesters" to gamble in stocks into a gravity-defying speculative mania pursued by the masses? The characteristic of any stock market bubble is well known: The rise in speculative fever, the piling into the hot stock of the moment to earn outsize rewards. And when the crash comes, stock prices plummet at a frightening speed.

INFINITE P-Es. It's puzzling how so many people could be so stupid with their money. How is it that investors during Web mania thought a price-earnings multiple of 100 was conservative, 1,000 plausible, and infinity conceivable? The most common explanation is investor irrationality. The mass of them seem simply to take leave of their senses. In a now legendary phrase, with greed run amok and morality bankrupt, investors exhibit "irrational exuberance." As Gustave Le Bon put it in 1895, "In crowds, it is stupidity and not mother-wit that is accumulated."

No doubt about it, enthusiasm spirals out of control during bubbles. But maybe investors aren't quite as stupid or ethically blind as their critics maintain. "Do we really believe that the New York Stock Exchange and the Nasdaq are temples to irrationality?" asks John H. Cochrane, finance professor at the University of Chicago. The economics of money offers insight into why prices of speculative stocks can reach wacky heights during a bubble.

Specifically, the concept of a "convenience yield" is useful, says Cochrane, who is among the profession's most insightful finance economists. He doesn't rely on the attractively vague notion of irrationality to explain the expansion and contraction of bubbles (see his paper, "Stocks as Money: Convenience Yield and the High-Tech Stock Bubble").

A BILL IN YOUR WALLET. First, let's define "convenience yield." In trading markets, this term reflects the benefits of directly owning a physical commodity -- say, the ability to profit from actually owning a barrel of oil or a silo of grain during a temporary market shortage. The convenience-yield concept also captures the difference between owning a Treasury bill that will be worth $100 a year from now and putting $100 cash in your wallet now and keeping it there for a year. Both are worth $100, but the bills in your wallet include the value of immediate access.

Cochrane argues that Internet stocks carried a high convenience yield during the height of the boom. Trading volume was extremely high. For instance, 19% of the publicly traded Palm shares on average changed hands in the first 20 days after its initial public offering. Creative/Ubid had a 106% average daily turnover.

Yet investors were chasing a scarce supply of shares. Excite had only 7 million publicly traded shares, compared to 671 million for Disney. The small float made it extremely difficult to short Internet stocks -- a bet that inflated share prices would tumble lower.

Thus, says Cochrane, the few shares available for trading carried a convenience yield. Investors knew Internet stocks were vastly overvalued over the long haul, but they were willing to own them because they wanted them for short-term trades. "You have to have the thing in hand when the bell hits," says Cochrane.

BULB BUBBLE. The boom also came to an end as Wall Street investment bankers worked round the clock to bring New Economy stocks to the market. The supply of Internet equity increased and, therefore, the convenience yield declined. In a sense, just like the money supply, the Internet "currency" depreciated with a swelling supply.

It's often forgotten that speculation emerges during times of major innovations and technological progress. For instance, Holland dominated the new market for tulips in Europe. The highest tulip prices were for particularly rare varieties not easily duplicated. The demand for these beautiful bulbs was driven by French fashion.

A growing auto industry, the rise of mass-production techniques, and the spread of electricity propelled the economic boom before the 1929 crash. And the longest economic expansion in U.S. history, the 1990s prosperity, was largely powered by substantial and sustainable productivity gains, as companies learned to exploit information technologies. At some point during a major transformation, it becomes especially difficult for investors to guesstimate tomorrow's profits, and opinions differ greatly.

A MYSTERY. Bubbles throughout history have not only been defined by high prices but also by high volume. And the subsequent bust has been distinct for low prices and low volume. The why behind the rise and fall in trading is a mystery.

Still, the concept of a substantial convenience yield or liquidity premium for stocks in a trading frenzy, especially when there's vigorous disagreement about the economic impact of a major new technology, is an intriguing explanation for the high prices of Nasdaq tech stocks at the turn of the millennium. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online

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