Ever wondered why an asset or asset class maintains an implausibly high price? A new IMF paper summarizes research on “bubbles”, the phenomenon of a lasting overvaluation. It suggests, for example, that the focus on relative performance among asset managers and the presumption of informed decisions by peers causes herding. Also, limited liability of managers and leveraged institutions encourages upside risk taking. Meanwhile, sell-side research, rating agencies, and accountants often lack the incentives to pre-emptively reveal downside risks. Political and institutional aversion to short selling aggravates overvaluation bias.
Asset Price Bubbles: A Selective Survey, Anna Scherbina
IMF WP/13/45
http://www.imf.org/external/pubs/ft/wp/2013/wp1345.pdf
“A bubble is a deviation of the market price from the asset’s fundamental value. .. We can define a positive bubble occurring when an asset’s trading price exceeds the discounted value of expected future cash flows ”
Why persistent overvaluation is more common than persistent undervaluation
“Value investors specialize in finding and investing in undervalued assets. In contrast, short sellers, who search the market for overvalued assets are routinely vilified by governments, the popular press, and…the overvalued firms…. England banned short selling for much of the 18th and 19th centuries, Napoleon declared short sellers to be enemies of the state, and many countries today either ban or severely restrict short selling.”
“Trading against an overvaluation involves the additional costs and risks of maintaining a short position, such as the potentially unlimited loss, the risk that the borrowed asset will be called back prematurely, and a commonly charged fee that manifests itself as a low interest rate paid on the margin account… ”
“A positive or negative mispricing may arise when initial news about a firm’s fundamentals moves the stock price up or down and feedback traders buy or sell additional shares in response to past price movement without regard for current valuation, thus continuing the price trend beyond the value justified by fundamentals. However, because of the potentially nontrivial costs of short selling an overvaluation will be less readily eliminated, making positive bubbles more common.”
The factors propagating persistent overvaluation
“The [classical] literature on rational bubbles derives conditions under which bubbles can occur when all agents are perfectly rational. One powerful conclusion is that when all agents are perfectly rational and all information is common knowledge, bubbles can exist for an infinitely-lived asset if the bubble’s rate of growth is equal to the discount rate.”
“The new generation of rational models identifies the incentive to herd and the limited liability compensation structure as pervasive problems that encourage professional money managers to invest in bubbles. Another problem contributing to bubbles is that information intermediaries are not paid directly by investors, and their incentives are not always compatible with reporting negative information.”
Factor 1: Herding
“Herding in investment decisions by investors and money managers is shown to be an important mechanism for sustaining and propagating bubbles… DeMarzo, Kaniel, and Kremer (2008) a relative wealth model, in which an individual agent’s utility depends not only on her absolute wealth but also on her relative wealth. If that dependence is strong, agents will prefer to participate in bubbles as long as other agents do so in order not to fall too far behind their peers’ wealth during the bubble’s upside. Shiller (2002) [suggests that] due to limited time and resources, money managers cannot thoroughly investigate every potential investment. A money manager observing her peers investing in a particular asset may conclude that their decision is based on compelling private information and may then choose to add that asset to her portfolio.”
“Betting against the herd is very costly while the bubble is on the rise; the managers who cannot keep up with their peers suffer fund outflows as investors reallocate funds to the more successful managers. As in the previously discussed model, reputational penalties are more severe when the manager is wrong at the time when the rest of the investment community is right than when everyone is wrong.”
Factor 2: Limited liability
“Most market players enjoy limited liability….an agent benefits from a rising bubble but does not suffer to an equal extent when the bubble bursts…This convex payoff structure generates a preference for risk and for riding bubbles…the magnitude of the bubble increases with the riskiness of the asset.”
Factor 3: Incentives not to report negative information
“Equity analysts hold back negative views about the firms they cover, rating agencies are reluctant to issue low bond ratings, and accounting auditors overlook questionable reporting choices. ”
“In the aftermath of the dot-com bubble, it was revealed that analysts frequently issued “strong buy” recommendations while privately holding [negative] views about the firm. The reasons are threefold. First, analysts fear…they may lose favour with its management and be shut out of future communication. Second, analysts stand to profit from the investment banking business they help generate by issuing favourable stock recommendations. Third, because sell-side analysts are paid a fraction of the trading commissions…and due to the widespread reluctance to sell short, it is easier to generate trade by issuing “buy” rather than “sell” recommendations.”
“Rating agencies and accounting auditors are paid by firms rather than by investors and are understandably reluctant to cause trouble for their clients and risk losing business.”
