#financialbubbles

[jakobsteffen]

Bubbles on financial #markets, past and present.

But this time surely is different, isn't it...?

[stag28]

"What causes asset bubbles? [..] despite decades of research, finance academics have been unable to agree on a cause for this phenomenon. Do investors suddenly become optimistic about asset fundamentals, only to realize a couple of years later that it was all a mirage? Do they buy at prices they know are inflated, hoping to find a greater fool to sell to before the crash? Or do they simply follow the herd? One possibility is that investors simply make mistakes when projecting future asset returns. If stocks have had an outstanding run for the past five years, or if earnings growth seems to have shifted to a faster trend, people might decide that this is the new normal, and pay prices that later turn out to be ludicrous. [..] a small but increasing number of papers are asking how markets would behave if investors improperly extrapolate recent trends into the future. [..] it doesn’t take very much human error to generate extrapolative expectations. If people start believing, even for a short time, that recent trends are the new normal, they will start paying higher prices, which locks the trend in place and lends credence to their belief. Eventually things spiral out of control before they come to their senses. Other economists have shown that even if just a fraction of investors think this way, it can cause repeated bubbles. [..] how do you know whether demand will increase? One obvious way is to look at recent trends. If prices have been going up, it’s a signal that the area is hot. [..] Extrapolative expectations can be used to account for a number of the phenomena that have puzzled and fascinated finance theorists for years. A 2013 paper by James Choi and Thomas Mertens showed that this kind of expectation formation can explain why U.S. stocks have enjoyed much higher returns than bonds for so many decades. [..] more and more theories are showing that extrapolative expectations might be the answer to many of our financial and economic puzzles."