October 28, 2003
Vernon Smith on Vulnerability to Bubbles

Tyler Cowen writes about Vernon Smith's echoing of Charles Kindleberger's rule-of-thumb that you can't get a bubble within a decade of the past bubble: Marginal Revolution: Once burned, twice shy?: Our colleague Vernon Smith argues that new traders are most susceptible to asset market bubbles, largely because of their inexperience. If the market rises again after a bubble bursts, we should take the run up in prices seriously: Smith points out that market double dips don't occur in rapid sequence. Indeed, since 1926 the space between down years for the broad market has always been at least two years, and usually much longer, according to Ibbotson Associates data. The closest sequence in the recent past was the two positive years between the 1973-74 bear market and the 7% downturn in 1977. In other words, Smith argues that the second round of high prices is usually for real. Experience has beaten the traders down into a state of fearfulness, so presumably there is good grounds for their optimism. I would like to see the more systematic time series evidence, in the meantime here is the article from Forbes. Here is my favorite part from the article: To Professor Smith, bubbles perform...

Posted by DeLong at 09:37 AM

August 27, 2003
Behavioral Finance: Herding

John Griffin, Jeffrey Harris, and Selim Topaloglu (2003), "The Dynamics of Institutional and Individual Trading," Journal of Finance (December). Abstract: We study the daily and intra-daily cross-sectional relation between stock returns and the trading of institutional and individual investors in NASDAQ 100 securities. Based on the previous day's stock return, the top-performing deciles... is 23.9% more likely to be bought in net by institutions... than... the bottom performance decile. Strong contemporaneous daily patterns can largely be explained by net institutional (individual) trading positively (negatively) following past intra-day excess stock returns (or the news associated therein). In comparison, evidence of return predictability and price pressure are economically small. Is this positive-feedback trading by institutions, or formal and informal limit buy and sell orders by individuals?...

Posted by DeLong at 12:43 PM

July 22, 2003
Panic in the Bond Market?

Morgan Stanley's Stephen Roach sees a bond-market panic driven by depressed "animal spirits" on the part of bond traders. The Federal Reserve needs to keep long-term interest rates low to spur investment and recovery. How it can do this if it is indeed the case that long-term bond interest rates are now being set by panicked traders rather than forward-looking economists is a mystery: Morgan Stanley: ...There are a number of alternative explanations to this dramatic sell-off in the bond market.† There are those, of course, who claim that signs of incipient economic recovery have turned the bond market inside out.† While I'm hardly objective on that point, even the diehard growth optimists concede that the evidence remains mixed at this point and that the vigorous recovery call is still a forecast (see Dick Bernerís July 18 dispatch, "Recovery Signs").† Others have argued that the rapidly deteriorating federal budget deficit is the culprit, sparked by the administrationís midyear confession that the budget shortfall is likely to hit $455 billion in the current fiscal year.† While I would be the last to minimize the significance of this development, it hardly qualifies as the singular surprise that can explain the bond marketís...

Posted by DeLong at 12:53 PM

April 10, 2003
Notes: LTCM

A short summary of what went wrong at LTCM....

Posted by DeLong at 09:35 PM

Notes: More Finance Demand Curves Sloping the Wrong Way

Notes: Teaching: Econ 236: Behavioral: Finance: Yet More Demand Curves That Slope the Wrong Way This time it's due to performance-based arbitrage: PBA: circumstances in which the fact that prices move against fundamentals leads investors to think that their smart-money managers aren't so smart, and so withdraw funds: From Andrei Shleifer and Robert Vishny (1995), "The Limits of Arbitrage" (Cambridge: NBER Working Paper 5167). One model of risky arbitrage is that of a large number of investors taking small positions against the mispricing. Fama's (1965) classic analysis of efficient markets and Ross's (1976) Arbitrage Pricing Theory are based on this model. An alternative, and in many cases more realistic view, is that arbitrage is conducted by a few professional, highly-specialized investors who combine their knowledge with resources of outside investors to take large positions. They operate in markets where fundamentals are difficult to ascertain and correct hedging strategies are hard to implement, such as the currency and derivative markets. The fundamental feature of such arbitrage is that brains and resources are separated by an agency relationship. the money comes from wealthy individuals, banks, endowments, and other investors with only a limited knowledge of individual markets, and is invested by arbitrageurs...

Posted by DeLong at 03:49 PM

Notes: Risk Aversion

Teaching Notes for Econ 236: April 9: What do different risk aversion parameters imply about gambles? Kocherlakota (1995) [Narayana R Kocherlakota (1995), "The Equity Premium: It’s Still a Puzzle," Journal of Economic Literature, 1996-1, pp. 42-72.] reports that the raw "equity premium puzzle" implies a coefficient of relative risk aversion of 18... (and then there is the risk-free rate puzzle: at a crra of 18, you need a raw time preference factor of -8% per year to fit average per-capita consumption growth to the average real risk-free rate of interest. What does such a high risk aversion parameter mean? Well... ...At a coefficient of relative risk aversion of 1... you are indifferent between a this year's consumption level of $30,000 for certain and a 58% chance of $40,000 coupled with a 42% chance of $20,000. ...At a coefficient of relative risk aversion of 5... you are indifferent between a this year's consumption level of $30,000 for certain and a 86% chance of $40,000 coupled with a 14% chance of $20,000. ...At a coefficient of relative risk aversion of 10... you are indifferent between a this year's consumption level of $30,000 for certain and a 97.6% chance of $40,000 coupled with...

Posted by DeLong at 03:44 PM

June 01, 1990
J. Bradford DeLong, Andrei Shleifer, Lawrence H. Summers, and Robert J. Waldmann (1990), "Positive-Feedback Investment Strategies and Destabilizing Rational Speculation," Journal of Finance 45: 2 (June), pp. 374-397.

J. Bradford DeLong, Andrei Shleifer, Lawrence H. Summers, and Robert J. Waldmann (1990), "Positive-Feedback Investment Strategies and Destabilizing Rational Speculation," Journal of Finance 45: 2 (June), pp. 374-397....

Posted by DeLong at 03:12 PM

Robert B. Barsky and J. Bradford DeLong (1990), "Bull and Bear Markets in the Twentieth Century," Journal of Economic History 50: 2 (June), pp. 1-17.

Robert B. Barsky and J. Bradford DeLong (1990), "Bull and Bear Markets in the Twentieth Century," Journal of Economic History 50: 2 (June), pp. 1-17....

Posted by DeLong at 03:10 PM

July 01, 1989
J. Bradford DeLong, Andrei Shleifer, Lawrence H. Summers, and Robert J. Waldmann (1989), "The Size and Incidence of Losses from Noise Trading," Journal of Finance 44: 3 (July), pp. 681-696.

J. Bradford DeLong, Andrei Shleifer, Lawrence H. Summers, and Robert J. Waldmann (1989), "The Size and Incidence of Losses from Noise Trading," Journal of Finance 44: 3 (July), pp. 681-696....

Posted by DeLong at 12:21 PM