Investment opportunities during stock price bubbles

Topics: Stock market, Fundamental analysis, Dot-com bubble Pages: 14 (4471 words) Published: September 24, 2013


INVESTMENT OPPORTUNITIES DURING STOCK PRICE BUBBLES

Table of contents

1. Introduction…………………………………………………………………………………… 2. The movements of stock prices……………………………………………………………….. 3. The existence of stock price bubbles………………………………………………………….. 4. The limitations to arbitrage……………………………………………………………………. 5. Heterogeneities among rational arbitrageurs................................................................................ 6. Stock bubble trading and exit strategies………………………………………………………... 7. Conclusion……………………………………………………………………………………… References……………………………………………………………………………………….

1. Introduction

Interesting thoughts have been released on how investors should trade with stock movements. The dynamics of modern trading strategies are primarily based on one of the most important studies ever written in financial management: Technical analysis on stock trends by Robert D. Edwards and John Magee. Their work emphasized techniques that could be used to identify stock patterns in order to predict future stock prices. The introduction of technical analysis went beyond fundamental analysis that focused completely on financial statement analysis. One of the implications of the new method implied that stock prices moved within a certain range around its true, fundamental value. This concept introduced a totally new trading strategy to financial markets: it became possible to (irrationally) speculate on stock prices, in other words: even when rational investors knew that stock prices were above their fundamental values, it could still be attractive to ‘trade with the stock’, as long as they believed that the prices would grow further.

The situation where a rapid expansion of the stock price is being followed by a sharp decline, while the fundamental value remains unchanged, is called an (economic) bubble. As we will show, the existence of bubbles goes against predictions made by the efficient market hypothesis. The latter perceives investors as being more or less homogeneous, while opponents of this view also take ‘behavioural’ elements that lead to momentum trading and trend chasing into consideration. The second paragraph of this paper deals with these different views. The third paragraph discusses the existence of arbitrage opportunities. A topic that is connected directly to the theoretical views discussed before. As one might have expected, proponents of the efficient market hypothesis believe that arbitrage opportunities do not exist, or when they do: that they will be corrected immediately due to the behaviour of rational investors. This section introduces the reader with the appearance of stock price bubbles and tries to make clear what its relation is to the concept of arbitrage. Before we draw any conclusions about correct investor behaviour, we discuss the empirical evidence of three famous crashes: the tech bubble, the tulip mania and the recent real estate bubble. What are the similarities and differences of these crashes? And what were their consequences on (investors) welfare? The fourth paragraph deals with the limitations to arbitrage. It shows that, even when arbitrage opportunities exist, it might still be risky to bet them. Afterwards, we continue with a special view of the appearance of bubbles, namely the one described in an influential article by Abreu & Brunnermeier (2003), that even when all investors behave rationally, it is still possible to successfully drive a bubble. The paper concludes with trading and exit strategies that institutional and individual investors could use to capture bubble arbitrage. When evaluating past behaviour it might be possible to identify recommended directions for the future.

2. The movements of stock prices

Various chartist theories have tried to identify relationships between historical and future stock prices. The...

References: 1) Abreu and Brunnermeier, 2003, Bubbles and Crashes, Econometrica 71, 173-204.
2) Brock, Lakonishok, LeBaron, 1992, Simple Technical Trading Rules and the Stochastic Properties of Stock Returns. The Journal of Finance
3) Brunnermeier and Nagel, 2004, Hedge Funds and the Technology Bubble, Journal of Finance 59, 2013-2040
6) De Long, Shleifer, Summers and Waldmann, 1990b, Positive Feedback Investment Strategies and Destabilizing Rational Speculation, Journal of Finance 45, 379-395.
7) Dow and Gorton, 1994, Arbitrage chains, Journal of Finance 49, 819–849
8) Edwards and Magee, 1948, Technical analysis of stock trends, book & online pdf
9) Fama, 1965, The Behavior of Stock Market Prices, Journal of Business 38, 34-105.
10) Greenwood and Nagel, 2009, Inexperienced Investors and Bubbles, Journal of Financial Economics 93, 239-258.
13) Shleifer and Vishny, 1997, The Limits of Arbitrage, Journal of Finance 52, 35-55.
14) Temin and Voth, 2004, Riding the South Sea Bubble, American Economic Review 94, 1654-1668.
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