Bubbles, shorting and IPOs

II. Bubbles, shorting and IPOs

For anyone who has done a fair bit of reading on financial markets, to see the BBC programme ‘The Super Rich and us’ educating the public on the Black-Scholes-Merton model, the birth of securitization of mortgages or traders’ rationality is almost cute. While we can easily agree to disagree with some of the positivism around the presentation of those concepts, we feel that some financial education is better than none.

With or without the background knowledge, we thought our second part of the series The (ir)rational Markets (did you see the first?), may be an interesting read for anyone who is aware of financial bubbles’ existence or ‘shorting’ but wondered who comes up with those concepts. Not us.

II. Bubbles, shorting and IPOs

Define it. The Oxford English Dictionary defines a bubble as ‘…a significant, usually rapid, increase in asset prices that is soon followed by a collapse in prices and typically arises from speculation or enthusiasm and not from intrinsic increases in value.’ In addition, Shiller argues that the true meaning of a speculative bubble lies in the potential for ‘less than rational’ behaviour exhibited by investors. Even though defining the term is straightforward, what remains challenging is identifying the mechanisms that create a bubble.

Short it. The traditional economic explanation of a financial bubble focuses on the short sale* constraints, namely the way institutions create high cost and high risk of shorting that lead to investors’ inability to short particular stocks. Hence, it is argued that when a stock cannot be shorted, it is overvalued. This concept is supported by Miller who sees short sale constraints as preventing the flow of negative information and its expression in stock prices, thus effectively arguing against Fama’s hypothesis that all available information is contained in a stock price.

Rationalise it. The same rationale also underpins the effects of heterogeneous beliefs among agents. It has been argued that when agents ‘agree to disagree’, asset prices exceed their fundamental value, although one can argue that these constraints are insufficient for a stock price to rise considerably above its fundamentals. While it could be anticipated that some rational investors might not see the opportunity of shorting overpriced stock because of these constraints, it may be less likely that overpriced securities would have enough buyers. However, combining ‘trading costs and downward sloping demand curves’ of investors explains why this may not be the case. Differences in opinions are indeed reflective of the ‘rational speculative behaviour’ that creates a bubble where the ‘speculative premium’ is even higher than the most confident investor’s valuation.

Disperse it. The supporting evidence about the relationship between divergence of opinion and IPO long-term performance further substantiates Miller’s theory of IPO overvaluation as well as of Shiller’s behavioural theory claiming that IPO prices could be driven to unreasonable levels due to the ‘illusion of knowledge’ effect. Their results reiterate the notion that market efficiency is challenged due to investors’ optimism, the later overvaluation, the presence of short sale constraints and dispersion of opinion.

To be continued… (See Part III)

Suits and Books. Our pleasure.

*Short selling is one of the ways to profit from the decrease in the price of a security, which could be either a stock or a bond. It could be suggested that when due to a constraint no bet against a particular stock can be made then that stock can become overvalued.