Why has the stock market recovered so quickly from its 10% swoon over three sessions in late October? Was there some positive news that caused millions of investors to put on green eyeshades, fire up their spreadsheets, and conclude that the real value of stocks exceeded current market prices? That's what a believer in the efficiency of markets would say. An alternate theory is that instead of scrutinizing the assets of companies, investors scrutinized one another for clues about what to do. They concluded that other investors would buy on the dip--so they did it themselves. And stock prices shot back up.
If that's really what happened, it's a classic example of a self-fulfilling prophecy. It's also a recipe for a "market bubble," a speculation-induced inflation of prices above their true value, say economists who study investment behavior. While Wall Street analysts are applauding the market's rebound, these economists warn that investors may, like Humpty Dumpty, be setting themselves up for a great fall.
INCIPIENT MANIA. A bubble in the stock market can lead to overinvestment by giving companies a perception that their cost of capital is low. Likewise, the popping of a bubble can lead to cascading defaults by overextended investors and lenders and, eventually, a deep chill in the productive sector of the economy. You start to see why Federal Reserve Chairman Alan Greenspan warned last December against "irrational exuberance."
Of course, there's no way to be sure that the stock market is overvalued at these levels--or even at the level of last August, when the Dow Jones industrial average briefly topped 8200. But investors' behavior has many of the earmarks of incipient mania, say many behavioral-finance experts. "My view, for what it's worth, is that there is a lot of risk," says Harvard University economist John Y. Campbell.
So, where do investors get the confidence to keep bidding up stock prices even after last month's warning slap? Aside from the assurance bred by a decade-long bull market, investors may be buoyed by the idea that financial markets settle naturally at their proper level. Economists call this the efficient-markets theory. The idea, which reached its zenith in the 1970s and early 1980s, is that you can't beat the market, because prices adjust to news far faster than you can react. A corollary is that there's no need to fear bubbles, because stock prices never get too far out of line.
But before you put too much faith in the theory of market efficiency, consider that ever since the mid-1980s, it has been falling from favor in academia --where it began. Most financial economists now agree with the commonsense observation that stocks and other financial assets are subject to bubbles, overshoots, and panics. Efficient-markets theory assumes that investors focus on fundamental values of assets. But if what they really focus on is one another, all bets are off.
Even those academics who remain in the efficient-markets camp have begun to acknowledge its limits. "Fifteen years ago, people's knee-jerk reaction was, `Prices are right,"' says Yale University economist Kenneth R. French. "As the world moves on, everybody revises their opinions."
Still, a continuing conviction that it's impossible to beat the market has led small investors to put more money into index mutual funds, which represent broad swaths of the market. Morningstar Inc., a Chicago-based fund research firm, says assets in stock and bond index funds rose to $140.6 billion as of Sept. 30, from $2.1 billion in 1987.
While that may be a good way to invest, it probably contributes to the potential for a market bubble. Fund investors--one step removed from thinking about the priciness of individual stocks--may get careless about searching for fundamental value.
Robert J. Shiller, a behavioral finance economist at Yale, says that in a recent survey he did, half the investors admitted that they weren't good at picking stocks, but for some reason most thought they were good at picking people who were good at picking stocks. Such hubris can be dangerous, he says: "People begin to believe any price is as good as any other. The danger is that the market can never seem too high."
Bubbles can persist for so long that they start to seem unpoppable--witness the long heyday of Japan's stock and real estate markets in the 1980s. People begin to think of the high levels as normal, a phenomenon known as "anchoring" (box). But when bubbles do pop, the effect can be explosive. Investors who have lost the habit of thinking about underlying values can panic--and not come in to buy even when the market hits bargain levels.
This isn't to say that markets are completely inefficient, either. If everyone thought it was obvious that the U.S. stock market was at too high a level, the market would quickly fall. The same goes for individual stocks: Markets are efficient enough that there are no easy pickings. "Average investors who try to do a lot of trading will just make their brokers rich," says Harvard economist Michael C. Jensen, an efficient-markets believer.
BEAUTY CONTEST. For the most part, then, bubble theorists don't waste time trying to time the ups and downs of the market or to pick particular undervalued stocks. Instead, they attempt to use insights from behavioral finance to exploit oddities in the way markets behave.
One such mini-bubble is the market's infatuation with stocks that have high price-earnings multiples. Such stocks, common in booming sectors such as high tech, tend to perform worse over three to five years than companies with low p-e's. It could be that investors unwisely assume that whatever misfortunes lead to a company's low p-e ratio are bound to continue--the "overconfidence" error in the box. As long ago as the 1930s, investment wizard Benjamin Graham spelled out the obvious strategy: Buy "value" stocks with low p-e multiples and hold them until the market wakes up to them.
If markets were efficient, that "value" anomaly should have been arbitraged away long ago, as people bought the value stocks and sold the high p-e growth stocks. But the anomaly was confirmed as recently as 1993 in a paper by Josef Lakonishok of the University of Illinois, Andrei Shleifer of Harvard, and Robert Vishny of the University of Chicago. They went on to found Chicago-based LSV Asset Management, which manages $1.3 billion of pension-fund money with a value strategy.
With the toppling of efficient-markets theory from its place of dominance, academics are harking back to earlier thinkers such as John Maynard Keynes, who said in the 1930s that bubbles can form and burst because investors focus on one another instead of on the fundamentals. Wrote Keynes: "It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be."
Keynes's description of the stock market as a beauty contest is a progenitor of Alan Greenspan's warning against irrational exuberance. The message: You can't always trust the stock market to get things right.