When Emotions
Guide Investors
By
HAL R. VARIAN
New York Times, July 3, 2003
The
stock market has come back from the dead, with the Standard & Poor's
500-stock index up 13 percent so far this year. Even the formerly moribund
technology sector is reviving, with the Nasdaq showing a 26 percent return
since January.
According
to recent news reports, much of this renewed vigor is driven by retail
investors. Is this a rational response to undervalued technology stocks,
or the start of another bubble?
To
gain some perspective, it is helpful to examine a recent post-mortem on
the dot-com boom by two professors at New York University's Stern School
of Business, Eli Ofek and Matthew Richardson. Their article, "DotCom
Mania: The Rise and Fall of Internet Stock Prices," was published in
the June 2003 issue of The Journal of Finance.
The
authors' explanation for the bubble has two components. First, there were
significant differences of opinion about the value of Internet stocks,
with retail investors tending to be much more optimistic than insiders or
institutions.
Second,
there were significant restrictions on short-selling those stocks, a way
of betting that they would decline. This prevented the pessimistic
expectations from being incorporated in market prices. The result was that
Internet stock prices were biased upward, with all-too-familiar
consequences.
This
story, or variations on it, is widely held to be a plausible explanation
for the bubble. The contribution of Mr. Ofek and Mr. Richardson is to
assemble a mass of detailed evidence that supports this analysis.
Start
with short selling. When investors sell stocks short, they deposit an
amount of money with their brokers, which earns interest. The interest
rate is higher if shares of the stock that was sold short are readily
available.
For
Internet stocks this rate was substantially lower than for an average
stock, suggesting that finding shares to sell short was more difficult.
This low interest rate made the cost of selling Internet shares short
significantly higher than for other shares.
Despite
this, the percentage of Internet shares sold short was considerably higher
than for ordinary shares. Apparently the short sellers were so confident
that prices were overvalued that they were willing to pay the extra cost.
This
leads to the second piece of the story: the claim that there were widely
divergent views about the value of Internet stocks.
The
most important piece of evidence for this claim comes from examining the
difference between individual and institutional holdings of Internet
stocks. There is a fairly large body of literature showing that individual
investors are subject to behavioral biases, like overreliance on recent
performance. Institutions, on the other hand, appear to be more rational.
The
authors argue that dot-coms played a larger role in individual portfolios
than in institutional portfolios. For example, as of March 2000, dot-coms
were 4.4 percent of the overall market, but only 2.3 percent of pension
fund holdings.
Further
evidence comes from the authors' examination of large trades made between
institutions. They find that Internet stock prices rose the most when the
amount of such trading was low. This is consistent with the view that
institutional investors tended to avoid Internet stocks, with the result
that their prices were driven by excessively optimistic individuals.
As
a test of their theory, Mr. Ofek and Mr. Richardson look at what happened
to Internet stocks after they went public. During an initial offering,
only about 15 to 20 percent of a company's shares are sold to the public.
The underwriter typically requires the owners of the remaining shares to
refrain from selling for a certain period, known as the "lock-up
period."
At
the end of this period, typically four to six months, insiders are free to
sell.
Mr.
Ofek and Mr. Richardson compared the change in price at the end of the
lock-up period for Internet stocks with that for other stocks between 1998
and 2000. They found that Internet stocks dropped 4.1 percent in the five
days up to and including the end of the lock-up, while the typical stock
dropped 2.3 percent. They also demonstrated a large jump in volume after
the lock-up, followed by a subsequent slow drift down in prices.
In
the six months after lock-up expiration, the average Internet stock
declined by 35 percent relative to a representative index of Internet
stocks.
This
finding casts some light on why the bubble finally burst in the spring of
2000. During this period, almost $300 billion worth of shares were
unlocked, and a substantial number of insiders, venture capitalists, and
early investors unloaded shares. By that time, the number of optimistic
buyers willing to absorb these shares had been exhausted. Prices started
falling, eventually turning even the optimists sour, and the bubble
collapsed.
Much
has been written about the betrayal of the small investor. But venture
capitalists made no bones about the fact that they were selling. After
all, that is what an initial offering is: insiders selling shares to
outsiders.
Of
course, there is no excuse for fraud and misrepresentation. But if those
in the best position to know the long-term value of a stock were so eager
to sell, one would think that would convey the message that dot-com
valuations were too high. The market eventually got that message, but it
took a long time.
What
lesson can we draw from the Ofek-Richardson account about the current
revival in tech stocks? It is that constraints on short-selling are still
with us, so the market is still susceptible to irrational exuberance on
the part of small investors.
Unfortunately,
it is reportedly the most speculative stocks — biotech, Chinese Internet
and penny stocks — that are showing the biggest price surges, and most
of the interest appears to come from individuals. Analysts, whose views
might be more representative of institutional investors, appear to be
sitting on the sidelines.
If
this pattern persists, it does not bode well for the current technology
recovery.
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