Bubbles and Contagion in Financial Markets, Volume Bubbles and Contagion in Financial Markets, Volume An Integrative View Eva R Porras Independent scholar, Spain © Eva R Porras 2016 All rights reserved No reproduction, copy or transmission of this publication may be made without written permission No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6-10 Kirby Street, London EC1N 8TS Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages The author has asserted her right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988 First published 2016 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS Palgrave Macmillan in the US is a division of St Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010 Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries ISBN 978-1-137-35875-2 DOI 10.1057/9781137358769 ISBN 978-1-137-35876-9 (eBook) This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin A catalogue record for this book is available from the British Library A catalog record for this book is available from the Library of Congress To Luis Javier Contents List of Tables and Figures Preface viii xi Acknowledgments xvi List of Acronyms xvii Introduction to Bubbles and Contagion Macro “Players” in Bubble Formation and Contagion Processes 31 Contributors to the Bubble Formation and Contagion Process 55 Bubbles versus the Valuation of Fundamentals 91 Bubbles and Technical Trading 127 Contagion 173 Bubbles 201 Notes 237 Author Index 277 Subject Index 281 List of Tables and Figures Tables 1.1 Viceroy bulb trade (1637) 2.1 Guarantor of debt when there is risk of default 41 3.1 Dual-system theory, two modes of thought 69 3.2 Question substitution by intuition 70 3.3 Ten behavioral biases and effects in financial services 80 4.1 Probability distribution for expected degree of service completion (x) 92 Probability distribution for expected degree of service completion 94 4.3 Blue Jacket, Inc income statement ($ millions) 106 4.4 Blue Jacket, Inc balance sheet ($ millions) 106 4.5 Blue Jacket, Inc changes for five-year forecast ($ millions) 108 4.6 Blue Jacket, Inc five-year forecast ($ millions) 109 4.7 Blue Jacket, Inc scenarios to calculate the RV 109 4.8 Blue Jacket, Inc liquidation value in the sixth year ($ millions) 110 4.9 RV for different scenarios 111 4.10 Blue Jacket, Inc ($ millions) 112 4.11 Final value for different scenarios without debt ($ millions) 113 5.1 The four basic categories of technical indicators 147 5.2 Elliott Wave classification 155 4.2 Figures 1.1 1.2 (a) Gouda Tulip Bulbs 1634–1637, (b) South Sea Company 1719–1722, (c) Nasdaq Composite 1990–2002, (d) Index of British Railway share prices 1830–1850 13 The bubble life cycle 24 viii List of Tables and Figures ix 1.3 Bubble resource misallocations 28 1.4 Yin-Yang cycle of bubbles and balance-sheet recessions 30 1.5 Contrast between Yin and Yang phases of cycle 30 2.1 A recent history of debt expansion, bubble formation, and bubble deflation, as narrated by the Standard & Poor’s 500 Index 34 2.2 Value and payoff of a guarantee 42 2.3 Nonlinear function of macro risk aggregation 43 2.4 Feedback loops from explicit and implicit guarantees 46 2.5 The financial accelerator effect 48 3.1 The value function of Prospect Theory 76 5.1 The line chart 132 5.2 Logarithmic (log) price scale and linear (arithmetic) price scale 133 5.3 Candlestick formation 134 5.4 Candlestick chart versus bar chart 135 5.5 A point and figure chart 136 5.6 Upward trend 137 5.7 Long-, medium-, and short-term trends chart 138 5.8 Chart with ascending channel 139 5.9 Support and resistance chart 140 5.10 Volume chart 141 5.11 Head and shoulders chart 142 5.12 Cup and handle chart 143 5.13 Double tops and bottoms chart 144 5.14 Wedge chart 145 5.15 Upward and downward trends with moving average 146 5.16 Fibonacci retracement chart 151 5.17 Fibonacci time zones 152 5.18 Elliott Waves, basic sequence 153 5.19 Elliott Waves, basic sequence correction 154 274 98 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113 114 115 116 117 118 119 120 121 122 123 124 125 126 127 Notes B T Diba and H I Grossman (1988) ‘The Theory of Rational Bubbles in Stock Prices’, Economic Journal, 98, 746–754 G W Evans and S Honkapohja (1992) ‘On the Robustness of Bubbles in Linear RE Models’, International Economic Review, 33, 1–14 Allen, Morris and Postlewaite, ‘Finite Bubbles with Short Sale Constraints’ J B Taylor (1977) ‘On the Conditions for Uniqueness in the Solution of Rational Expectations Models’, Econometrica, 45, 1377–1385 R J Shiller (1978) ‘Rational Expectations and the Dynamic Structure of Macroeconomic Models’, Journal of Monetary Economic, 4, 1–44 Blanchard, ‘Speculative Bubbles, Crashes and Rational Expectations’ Blanchard and Watson, ‘Bubbles, Rational Expectations, and Financial Markets’ D Quah (1985) ‘Estimation of a Nonfundamentals Model for Stock Price and Dividend Dynamics’, manuscript MIT Tirole, ‘Asset Bubbles and Overlapping Generations’ O’Connell and Zeldes, ‘Rational Ponzi Games’ Diba, ‘Bubbles and Stock-Price Volatility’ Shiller, ‘The Use of Volatility Measures in Assessing Market Efficiency’, 291–311 R P Flood and R J Hodrick (1986) ‘Asset Price Volatility, Bubbles and Process Switching’, Journal of Finance, 41, 831–842 J H Cochrane (1991) ‘Volatility Tests and Efficient Markets: A Review Essay’, Journal of Monetary Economics, 27, 463–485 S Ikeda and A Shibata (1992) ‘Fundamentals-Dependent Bubbles in Stock Prices’, Journal of Monetary Economics, 30, 143–168 B T Diba and H I Grossman (1988) ‘Explosive Rational Bubbles in Stock Prices?’, American Economic Review, 78, 520–530 Campbell and Shiller, ‘Cointegration and Tests of Present Value Models’ Diba and Grossman, ‘Explosive Rational Bubbles in Stock Prices?’ W Charemza and D Deadman (1995) ‘Rational and Intrinsic Bubbles: A Reinterpretation of Empirical Results’, Applied Financial Economics, 5, 199–202 F Allen and G Gorton (1988) ‘Rational Finite Bubbles’, Mimeograph, The Wharton School, University of Pennsylvania Published: F Allen and G Gorton (1993) ‘Churning Bubbles’, Review of Economic Studies, 60, 4(205), 813–836 http://www nber.org/papers/w3707 H L Han (1996) ‘Cointegration and Tests of a Present Value Model in the Stock Market’, Applied Economics, 28, 267–272 D Friedman and M Aoki (1992) ‘Inefficient Information Aggregation as a Source of Asset Price Bubbles’, Bulleting of Economic Research, 44, 251–279 Campbell and Shiller, ‘Cointegration and Tests of Present Value Models’ Diba and Grossman, ‘Explosive Rational Bubbles in Stock Prices?’ Evans, ‘Pitfalls in Testing for Explosive Bubbles in Asset Prices’ K D West (1987) ‘A Specification Test for Speculative Bubbles’, Quarterly Journal of Economics, 102, 553–580 R P Flood, R T Hodrick and P Kaplan (1986) ‘An Evaluation of Recent Evidence on Stock Market Bubbles’, National Bureau of Economic Research, Working Paper 1971, Cambridge, MA http://www.nber.org/papers/w1971.pdf West, ‘A Specification Test for Speculative Bubbles’ E Renshaw (1990) ‘Some Evidence in Support of Stock Market Bubbles’, Financial Analysts Journal, 46, 71–73 R Chirinko and H Schaller (1996) ‘Bubbles, Fundamentals, and Investment: A Multiple Equation Testing Strategy’, Journal of Monetary Economics, 38, 47–76 Notes 275 128 West, ‘A Specification Test for Speculative Bubbles’ 129 McQueen and Thorley, ‘Bubbles, Stock Returns, and Duration Dependence’ 130 Blanchard and Watson, ‘Bubbles, Rational Expectations, and Financial Markets’ 131 G W Evans (1986) ‘A Test for Speculative Bubbles in the Sterling-Dollar Exchange Rate: 1981–84’, American Economic Review, 76, 621–636 132 H Bierman (1995) ‘Bubbles, Theory, and Market Timing’, Journal of Portfolio Management, 22, 54–56 133 Flood and Garber, ‘Market Fundamentals versus Price-Level Bubbles’ 134 A Shleifer and R Vishny (1997) ‘The Limits of Arbitrage’, Journal of Finance, 52, 35–55; D Abreu and M K Brunnermeier (2003) ‘Bubbles and Crashes’, Econometrica, 71(1), 173–204 135 Diba and Grossman, ‘On the Inception of Rational Bubbles’ 136 B S Bernanke, M Gertler and S Gilchrist (1999) ‘The Financial Accelerator in a Quantitative Business Cycle Framework’, in J B Taylor and M Woodford, eds, Handbook of Macroeconomics (Elsevier Science B.V.), Chapter 21, pp 1341–1393 137 H Hong, J Scheinkman and W Xiong (2008) ‘Advisors and Asset Prices: A Model of the Origins of Bubbles’, Journal of Financial Economics, 89, 268–287 138 M K Brunnermeier and C Julliard (2008) ‘Money Illusion and Housing Frenzies’, Review of Financial Studies, 21(1), 135–180 139 G L Kaminsky, C M Reinhart and C A Végh (2003) ‘The Unholy Trinity of Financial Contagion’, Journal of Economic Perspectives, 17(4), 51–74 140 K Daniel, D Hirshleifer and A Subrahmanyam (1998) ‘Investor Psychology and Security Market Under- and Overreactions’, Journal of Finance, 53, 1839–1885 141 Bernanke, Gertler and Gilchrist, ‘The Financial Accelerator’ 142 A Scherbina (2008) ‘Suppressed Negative Information and Future Underperformance’, Review of Finance, 12, 533–565 143 W Xiong and J Yu (2011) ‘The Chinese Warrants Bubble’, American Economic Review, 101, 2723–2753 144 E Lefèvre (1923) Reminiscences of a Stock Operator, First published January 17th by Doubleday & Company E Published 2006 by John Wiley & Sons, p 180 145 M Jensen and W Meckling (1976) ‘Theory of the Firm: Managerial Behaviour, Agency Cost and Ownership Structure’, Journal of Financial Economics, 3, 305–360; J Stiglitz and A Weiss (1981) ‘Credit Rationing in Markets with Imperfect Information’, American Economic Review, 71, 393–410 146 J B De Long, A Shleifer, L H Summers and R J Waldmann (1990) ‘Positive Feedback Investment Strategies and Destabilizing Rational Speculation’, Journal of Finance, 45, 379–395 147 Abreu and Brunnermeier, ‘Bubbles and Crashes’ 148 M K Brunnermeier and S Nagel (2004) ‘Hedge Funds and the Technology Bubble’, Journal of Finance, 59, 2007–2034 149 Shleifer and Vishny, ‘The Limits of Arbitrage’; W Xiong (2001) ‘Convergence Trading with Wealth Effects: An Amplification Mechanism in Financial Markets’, Journal of Financial Economics, 62, 247–292; D Gromb and D Vayanos (2002) ‘Equilibrium and Welfare in Markets with Financially Constrained Arbitrageurs’, Journal of Financial Economics, 66, 361–407 150 R Sadka and A Scherbina (2010) ‘Mispricing and Costly Arbitrage’, Journal of Investment Management, 7, 1–13 151 De Long, Shleifer, Summers and Waldmann, ‘Positive Feedback Investment Strategies’ 152 R McKinnon and H Pill (1998) ‘International Over-Borrowing: A Decomposition of Credit and Currency Risks’, SCID Working Paper 19, Stanford University https:// siepr.stanford.edu/publicationsprofile/1611 276 Notes 153 F Allen and D Gale (1998) ‘Optimal Financial Crises’, Journal of Finance, 53, 1245–1284; B Bernanke (1983) ‘Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression’, American Economic Review, 73, 257–276; B Bernanke and M Gertler (1989) ‘Agency Costs, Collateral, and Business Fluctuations’, American Economic Review, 79, 14–31; B Holmstrom and J Tirole (1997) ‘Financial Intermediation, Loanable Funds, and the Real Sector’, Quarterly Journal of Economics, 112, 663–691 154 Bernanke and Gertler, ‘Agency Costs, Collateral, and Business Fluctuations’; N Kiyotaki and J Moore (1997) ‘Credit Cycles’, Journal of Political Economy, 105(2), 211–248; Bernanke, Gertler and Gilchrist, ‘The Financial Accelerator’, 1341–1393 155 H Shin (2010) Risk and Liquidity, Clarendon Lecture in Finance (Oxford, UK: Oxford University Press) 156 R Koo (2008) The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession (Singapore: John Wiley & Sons), p 160 157 M K Brunnermeier and Y Sannikov (2013) ‘A Macroeconomic Model with a Financial Sector’, April 17 158 B S Bernanke and M Gertler (1999) ‘Monetary Policy and Asset Price Volatility’, Economic Review, 84, 17–51 Author Index Akerlof, G.A 59 Allen, F 198, 221, 224 Alti, A 164, 165 Angeletos, G.M 62 Aoki, M 224 Aronson, D.R 159 Asem, E 194 Bachelier, L 160 Baek, E 190 Balenovich, D 166 Banerjee, A 185, 192 Barber, B.M 161 Barberis, N 21, 195 Barras, L 161 Batchelor, R 159 Becker, G.S 68 Bernanke, Ben 15, 35, 46, 227 Bikhchandani, S 185 Black, F 120 Blanchard, O.J 190, 222, 226 Brock, W.A 167, 190 Brunnermeier, M.K 49, 228 Buffett, W 131, 181 Caballero, R.J 51 Caginalp, G 166 Calandro, J 62 Campbell, J.Y 223, 224 Charemza, W 223 Chiarella, C 166 Chirinko, R 225 Claessens, S 173 Daniel, K.D 166, 194 Davis, J.B 62 Deadman, D 223 DellaVigna, S 79 DeLong, J.B 188, 189, 194 DeMarzo, P.M 197 DeSantis, M 166 Diba, B.T 220, 221, 222, 223, 224, 227 Dieci, R 166 Dornbusch, R 173 Draghi, M 46 Dufwenberg, M 218 Ermentrout, G.B 166 Evans, G.W 221, 224, 226 Fahlenbrach, R 66 Fama, E 97, 160, 161 Festinger, L 63 Flood, R.P 225 Forbes, K 173 Frazzini, A 197 French, K 161 Friedman, D 224 Froot, K.A 210 Galbraith, J.K xii Gale, D 198 Garber, P.M 7, Gardini, L 166 Gennotte, G 190 Gertler, M 46, 227 Gervais, S 166 Getmansky, M 39, 46 Giavazzi, F 39, 45, 46 Gilchrist, S 46, 227 Gilles, C 207 Goldgar, A Gorton, G 49, 198, 224 Graham, J.R 187 Gray, D 39, 46 Greenspan, A 18 Grinblatt, M 164 Grossman, G.M 207 Grossman, H.I 221, 223, 224, 227 Hajjar, G.Z 34 Hall, B.J 66 Hamilton, J.D 102 Han, H.L 224 Hirshleifer, D 166, 185, 194 Hodrick, R.T 225 Hommes, C.H 167 Honkapohja, S 221 Ikeda, S 277 223 278 Author Index Obstfeld, M 210 O’Connell, S.A 220, 222 Odean, T 161, 166 Ozdenoren, E 62 Jensen, M.C 66 Jevons, W.S 212 Julliard, C 228 Kahneman, D 69, 70, 72, 75, 76, 77 Kaniel, R 164, 197 Kaplan, P 225 Keim, D.B 169, 170 Keynes, J.M xii, 37, 48, 81, 186 Kindleberger, C.P 191 Kirman, A 181, 191 Klaes, M 62 Knight, F.H 51, 52 Koo, R 29, 30 Kouwenberg, R 169 Krelage Kremer, I 197 Krishnamurthy, A 49 Krugman, P 34 Lamont, O 197 Leach, J 190 Lefèvre, E 231 Leland, B 218 Leland, H 190 Lev, B 218 Liebman, J.B 66 Lindqvist, T 218 Lo, A.W 39, 41, 46 Lorenzoni, G 62 Lux, T 191 Ma, T 168 Mackay, C 7, 8, Malkiel, B.G xii Mandelbrot, B 158 McQueen, G 226 Meckling, W.H 66 Merton, R.C 41, 46 Merton, R.K 60 Miller, E 193 Minsky, H.P 26, 27, 37, 48, 49, 50 Moore, E 218 Morgenstern, O 74 Morris, S 221 Murphy, K.J 66 Neely, G 159 Neumann, J Von 74 Park, Y 173 Pavan, A 62 Pelizzon, L 41, 46 Popper, K.R 98 Postlewaite, A 221 Pound, J 192 Prechter, R 13, 155, 160 Ramyar, R 159 Renshaw, E 225 Rigobon, R 173 Rodrigue, J.P 24, 28 Sakakibara, K 207 Samuelson, P 160 Sandri, S 62 Scaillet, O 161 Schaller, H 225 Scharfstein, D.S 166, 197 Scheinkman, J 228 Scholes, M 120 Schumpeter, J 48 Shibata, A 223 Shiller, R.J 102, 192, 197, 222, 223, 224, 225 Shleifer, A 21, 188, 189, 194, 195 Simon, H 68 Smith, V.L 195, 217, 218 Sornette, D 159 Soros, G 60, 62, 170 Spence, M 59 Stanovich, K.E 69 Stein, J.C 194, 197 Stulz, R.M 66 Subrahmanyam, A 194 Suchanek, G.L 195, 217, 218 Summers, L.H 188, 189, 194 Taylor, J.B 221 Thomas, D.S 59 Thomas, W.I 59 Thorley, S 226 Tian, G.Y 194 Tirole, J 5, 102, 203, 220, 222 Titman, S 164 Author Index Topol, R 191 Tversky, A 69, 70, 72, 75, 76, 77 Uribe, M Werner, J 202 West, K.D 224, 225 Williams, A.W 195, 217, 218 62 Xiong, W Vishny, R 21, 195 Von Neumann, J 74 Waldmann, R.J 188, 189, 194 Wang, J 165, 190 Watson, M.W 190, 222, 226 Weber, A.A 33 Welch, I 185 Wermers, R 161, 164 228 Yanagawa, N 207 Yin, C.H 168 Yoeli, U 164 Yuan, K 62 Yue, V 62 Zeldes, S.P 220, 222 Zwinkels, R.C.J 169 279 Subject Index Aaron indicator, see technical analysis Accessibility 12, 69–71, 73 Accounting Profit 124–125 Value 42, 44, 107–115, 121, 125 see mental accounting see valuation Adaptative, see expectations Adverse selection 56, 59 Agency Cost 47, 55–58, 66–67, 232–233 Theory 66 See also stock options See also short-termist behavior Agents Agent/manager 56 Agent based simulation 62 Behavioral agent based model 169 Heterogeneous agent model (HAM) xvii, 167–170 Informed 187–188, 210 Principal-agent problem 55 Rational agent model, see rationality Uninformed 188 Von Neumann–Morgenstern (VNM) rational agent, see Von Neumann– Morgenstern (VNM) Alternative A-paper (Alt-A) xvii, 15 American International Group (AIG) xvii, 4, 17, 27 Argentina 179 Asia 173, 178, 179 Asymmetric information, see information Attribute substitution, see bias Autocorrelation 60, 63, 208, 225–226 Bad incentives, see incentives See also agency cost See also executive compensation Balance sheet recession, see recession Baltic bubbles, see bubbles Bank run, see runs Bankruptcy 4, 16, 27, 29 Bar chart, see technical analysis Bayes 20, 72, 229 Bear Stearns 4, 65 Behavioral finance xii, 61, 63–64, 68–89, 164, 197 Beliefs 62, 79, 80, 82–83, 212–213 see feedback see reflexive relations Bias Analyst bias 57 Attribute substitution 72–73 Communal reinforcement bias 163 Confirmation bias 163 Conservatism bias 20–21, 195, 229 Extrapolation, over-extrapolation bias 70, 72–73, 80, 83, 163 Framing effect bias 71–73, 80, 83–84, 228 Hindsight bias 82, 163 Hypothetical bias 80 Mental accounting bias 72, 80, 83 Optimism, over-optimism bias 72–73, 82, 89, 114, 122, 153, 211, 218–219 Overconfidence bias xii, 70, 72, 80, 82–83, 86, 163 Money illusion 228 Myopic behavior 190 Present bias 80–81 Pessimism bias 19, 60, 92, 93, 153, 193, 228 Projection bias 80, 83 Representativeness heuristic 20–21, 195, 229 Risk aversion bias 196 Selective thinking bias 163–164 Self-attribution bias 20, 82, 164–166, 194, 228 Self-deception bias 164 Small-sample bias 215 Time discounting bias 80–81 Bollinger bands, see technical analysis Bolivia 179 Book value (BV), see accounting value Bounded rationality, see rationality Brady Commission 178 Brazil 174, 179 281 282 Subject Index Bubble(s) Causes 17–23, 227–229 Conditions 19 Bounded rationality, see rationality Financial accelerator, see financial accelerator Financial linkages, see linkages Herding, see herding Trade linkages, see linkages Technical trading, see technical analysis see connectivity see fiscal policy see monetary policy see runs see technical analysis Consequences 27–30, 230–231 Balance sheet recession, see recession Government intervention, see government intervention Resulting misallocations 27–29 Definition 5–6, 10, 201–204 see fundamental value see valuation Detecting 96–100 History 6–16 Baltic bubbles 34 Dot-com bubble 1, 11–14, 21, 197 Housing bubble xiii, 1, 4, 14–19, 26, 27, 29, 31–34, 37–38, 64–66, 72–73, 81–87, 228 Literature 219–226 Accounting literature 218–219 Experimental settings 217–218 Railway Mania 10–11, 13, 24, 25, 26 South Sea Bubble 8–10 Tulip Mania 5, 6–8 Life cycle phases 23–30, 229–230 Models xiv, 98, 201–229, 234 Overlapping generations 198, 213, 220 Types Contagious bubbles 207 Deterministic bubbles 207 Fads 14, 21, 184, 185, 213–215, 229 Information bubbles 216–217 Intrinsic bubbles 19, 207, 210, 223 Ponzi 49, 193, 206, 220 Pyramids 49, 106, 193, 206, 220 Near-rational theories of bubbles xiv, 208–211 Rational bubbles 6, 19, 207–215, 217–225 Price level bubbles 207 Speculative bubbles 207 Stochastic bubbles 207, 215, 222, 223 Sunspots xiv, 207, 212–213, 221 Business Value, see valuation California 14 Cascades, see herding Chart analysis, see technical analysis Chartism, see technical analysis Chile China xi, 12, 34, 231 Citigroup 65 Columbia Pictures 125 Committee for Economic Development (CED) xvii, 66–67 Compaq Computer 125 Confirmation bias, see bias Connectivity 13, 38–46, 177 Conservatism bias, see bias Contagion 173–199 Behavioral models 191–196 Cascades, see herding Causes 17–23 Channels of propagation 176–180 Conservatism bias, see bias Definition 3–4, 173–175 Experimental settings 195–196 Feedback trading, see feedback See also technical analysis Flight to safety, see flight to safety Herding, see herding Noise traders models, see noise trader models Perverse incentives, see incentives Recent studies 196–199 Representativeness heuristic, see bias Self attribution bias, see bias Shift contagion 173 Short sale constraints 193 Social learning 180–182 Theories 184–199 Contagious bubbles, see bubbles Contingent Liabilities 41, 46, 114, 120 Claims 213 Corporate conservatism 185 Correlation 63, 66, 131, 173, 174, 187, 193, 196, 208, 223 Cost of capital 59 Subject Index Crash (stock market) xi, 3, 12, 13, 17, 61, 64, 73, 186–190, 201, 207, 217, 223, 225, 226, 231 Credit Bubble and expansion crunch 227, 228, 230, 232, 233 Crisis Default swaps (CDS) 2, 15, 40, 41, 53, 54, 85–88, 174, 176, 179, 227, 232, 233 Global Flows 34–38 See leverage CXO Advisory Group 161, 162 Cyprus DaimlerChrysler 12 Debt, see leverage Default risk viii see bubble Dell Computer 124 Delta 41, 44 Deregulation 39 Derivatives 17, 18, 123, 124 Deterministic bubbles, see bubbles Deutsche Bundesbank 33 Diabolic loop 54 Dynamic linear rational expectations (DLRE) xvii, 220, 222 See Bubbles Discounted cash flow (DCF) analysis/ value xvii, 100, 107–109 See also valuation Dividend discount model 115–116 See also valuation Dividend yield 115 See also valuation DJIA, see Dow Jones Industrial Average DLRE, see Expectations Dot-com bubble, see bubble Dow Jones Industrial Average (DJIA) vii, 160 Dual-System Theory viii, 2, 69–71, 85 Dutch Also see Netherlands East Indies Economic Instability, see risk Value 124–125 Value added (EVA) 116–117 Efficiency 98 Efficient markets 13, 101 283 Efficient market hypothesis (EMH) xvii, 102, 161 Efficient market theory 62 Elliott Waves, see technical analysis EMH, see efficient market hypothesis England, 8, see also Great Britain, UK Euphoria, financial xii, 12, 26, 27 European Central Bank 33 Executive compensation 64–67 See incentives Expectations Adaptative 211 Dynamic linear rational expectations (DLRE) xvii, 220 Rational (RE) xii, xiii, xiv, xviii, 209, 211, 212 Rational expectations equilibrium (REE) xviii, 62 Self-fulfilling xiii, 59–64, 104, 202, 206, 226 The role of 91–96 See bubbles See fundamental valuation See reflexivity Exponential moving average (EMA), see technical analysis Extensionality 71 Externalities and cross subsidiaries 86–87 Extrapolation, see bias Fads, see bubbles Fair market value, see fundamental value Fannie Mae 27 Fat tail distribution 167 Fed (US Federal Reserve System) xvii, 4, 14, 15, 32, 33, 34, 35 Feedback ix, xii, 10, 13, 14, 20, 22, 26, 35, 36, 49, 60–64, 216 Effects 54 Loop 21, 39, 45–47, 51, 171 Retrofeedback 16, 25, 228 Trading 164, 168–169, 193, 228–230, 233 Traders ix, 175, 184, 185, 189–194, 205, 216 See expectations See reflexivity Fiber optic cable 11 Fibonacci, see technical analysis Financial Crises Inquiry Commission (FCIC) xiii, xvii, 1, 3, 17, 18 284 Subject Index Financial accelerator 9, 21, 46–48, 227, 229 Linkages, see linkages Risk, see risk Fiscal policy 13, 29–34, 117 Flag, see Technical analysis Flight to safety 51, 53 Florida 14 Flows, see global flows Framing effects 71–72 France 2, 23 Freddie Mac 27 Fundamental Analysis and Components 117–123 Fair Value xii, xiii, 5–6, 19, 26, 53, 60, 127–129, 166–171, 184–189, 201–212, 214–217, 222, 224 Versus technical analysis 128–129 Valuation 91–126 See bubbles See contagion See technical analysis Game theory 74 General Electric (GE) xvii, 123 Germany 2, 117 Global flows 4, 13, 22, 34–38 See linkages See liquidity Golden Ratio 149, 150 Goldman Sachs 65 Government intervention 16, 55, 61, 89, 229, 231–235 See fiscal policy See monetary policy Granger Causality Test 190 Great Britain, see also England, UK Greater fool 218 Greece 2, 176 Guarantees 39–46, 48–49, 199, 228, 232 Haircuts 16, 52–53 Hedge Funds Herding xii, xiv, xv, 21–22, 164, 182–188, 197–198, 207, 229 Behavioral models 191–196 Differences in opinion and constraints 193 Feedback trading 61, 193–194 Biased self attribution 194 Representativeness heuristic and conservatism bias 195 Experimental settings 195–196 Cascades xiv, 21–22, 180–188, 190, 198 Empirical 184 Feedback and collective behaviors 63–64 Informational 182–184 Investigative 184 Limited liability 198–199 Noise trader models 188–191 Reputational 184, 197–198 Social learning 180–182 Theories 184–199 See behavioral finance See bias See contagion See executive compensation and incentives See feedback See incentives See reflexivity See speculative trading See technical analysis Heterogeneous beliefs 213 See agents Heuristics 72–73, 84–85 see bias Hindsight bias, see bias Household Balance sheet 6, 45, 207 Feedback loops 39, 176 Money supply 32, 49, 176 Sector 43, 46 Wealth 1, 14, 16 Hong Kong 174, 179 Housing bubble, see Bubble Hyperinflation 179 IBM 132, 136 Imitation 60, 183, 189 see also herding, positive feedback, social learning Incentives 6, 19, 50, 57, 58, 184, 196, 197, 227, 228, 233 Bad 64–67, 85, 86, 188 Perverse 197, 199, 205, 207 Indicators, see technical analysis Indonesia 173 Infinitely-lived asset 209, 210 Inflation xi, xii, 25, 27, 30–35, 38, 48, 97, 99, 101, 107, 117, 201, 228, 230 See also hyperinflation Subject Index Information Asymmetry xii, xiii, 23, 36, 52, 56–58, 86, 178, 190, 212, 221 Bubbles, see bubbles Induced bank runs, See runs Intermediation 59 Perfect 23, 210, 216 See reflexivity See fundamental valuation See technical analysis Informational cascade, see cascade Informational Price Theory (IPT) xvii, 187, 188 Institutional investor 24, 164, 169, 184, 186, 187, 192 Intensionality 71 International Monetary Fund (IMF) xvii, Internet 1, 11, 12, 26, 194 see bubbles Intrinsic Bubbles, see bubbles Fundamentals, see fundamental fair value Intuition viii, 3, 13, 69–71, 93, 94, 95, 99, 105, 182, 190, 193 see dual system theory Invariance 71, 73 see prospect theory Ireland 2, 34 Irrational behavior 18, 212 See bias See reflexivity See technical analysis Irrational exuberance 18 Italy January effect 129 Japan 26, 30, 178, 179 Jobless recovery 14 JPMorgan Chase & Co 4, 65 Keeping up with the Joneses 197–198 Keynesian beauty contest 181 Knightian uncertainty 51–52 Korea 173 Kurtosis 168, 225, 226 Latin America 124, 178, 179 See South America Law of Large Numbers 93 Law of Small Numbers 83 285 Learning 12, 14, 45, 59, 69, 79, 180–182, 183, 185 see social learning Lehman Brothers 16, 17, 27, 65 Lenders’ limitations 53 Leverage 23, 25, 26, 27, 34, 48, 50, 52, 53, 115, 175, 178, 179, 233 And cycles 62 Deleverage 29, 33, 36, 231 Ratio 36, 52 Spirals 52–53 see bubble see credit Limited Attention 80, 84 Line chart, see technical analysis Linkages Capital flows 178–179 Common creditors 178–179 Financial linkages 4, 22–23, 176–178 Global flows 4, 13, 22, 34–38 Surprise element 180 Trade linkages 180 See global flows See liquidity Liquidity 13, 186, 205, 206, 229, 230, 232 Excess liquidity 13, 18, 34, 97, 147, 229 Motivated trading 216 Spirals 36, 51, 52, 53, 233 Stock 58–59 Liquidation value 113–114 see valuation Loans 2, 4, 37, 40, 41, 42, 43, 44, 88, 179 See guarantees Loss aversion 77, 78, 80, 81, 82, 84 spiral 36, 52 Lucas Critique 60 Lucent Technologies xvii, 12 Malaysia 174 Malta Margin Calls 15, 23, 27, 178, 189, 232 Runs 52 Spiral 36 Market Capitalization 115 Imperfections and failures 55–56, 85–89, 212–213 MBS, see Mortgage-backed securities 286 Subject Index Mean 21, 24, 93, 104, 179, 195, 196, 202, 204, 208, 214 Arithmetic 144 Explosive mean 223 Golden mean 149, 150 Stationary mean 223 Mean-reverting 21, 24, 168, 195 Zero mean 208, 214 Memory 3, 12, 131 Mental accounting 72, 80, 83 Mental counting 83 Merrill Lynch 65 Mexico 8, 174 Microsoft 12, 139 Minority Report of the Financial Crisis Inquiry, see Financial Crisis Inquiry Commission Minsky moment 50 Misallocations, see bubble Momentum indicator, see technical analysis Monday effect 129 Monetary policy xiii, 14, 29, 30, 31–34, 35, 55, 117 Moral hazard 53, 56, 59, 176, 234, 235 Morgan Stanley 65 Mortgage-backed securities (MBS) xvii, 15, 16, 233 Moving average, see technical analysis Narrow Framing 71, 72, 80 National Association of Securities Dealers Automated Quotation (NASDAQ) Composite index viii, xviii, 12, 13, 135, 139, 141, 146, 152 Near-rational theories of bubbles See bubbles Neimark-Hopf bifurcation 167 Netherlands 6, Network 12, 46, 177 externalities 53–54 models 191 Neumann-Morgenstern (VNM) utility theorem xviii, 74 New York Stock Exchange (NYSE) xviii, 100, 132, 133, 136, 140, 142, 143, 144, 145, 151 Nikkei Index 123 Noise 136, 167, 194, 197, 216, 217 Traders xii, xiv, 168, 184, 188, 161, 217 Models 188–191 See technical analysis NYSE see New York Stock Exchange Optimism, See bias, optimism See bias, overconfidence Options Real 119–120 Stock 58, 65, 66, 120, 146, 149 Overconfidence, see bias Over-extrapolation, see bias Overlapping generations model, See bubbles Panic, financial 10, 14, 17, 26–27, 51, 129, 213, 231 Paradox of thrift 30, 37 Pareto efficiency 55 Peru 8, 179 Perverse incentives, see incentives Pessimism, see bias Philippines 174, 179 Point and figure chart (P&F), see Technical analysis Policy, see Fiscal See Monetary Ponzi, see bubbles Portugal Positive feedback trading, See feedback trading Preferences 19, 55, 68, 71, 73, 78–82 Present value (PV), see valuation Price level bubbles, see bubbles Price to earnings ratio 114–115 Private signal, see signal Prospect theory ix, 71, 73–78, 81–82 Public signal, see signal Pyramid, see bubble Railway Mania, see bubble Random variable 93, 212, 221 Random walk xii, 21, 188, 223 Theory 160 Ratings Agencies 57, 199 Bond 57 Credit 2, 15, 18 Sovereign credit 45 Rational Agents 27, 76, 86, 168, 207, 234 Behavior 18, 20, 50, 212 Bubbles, see bubbles choice 68–69 Expectations, see expectations Subject Index see Bias see Herding see Prospect theory see Technical analysis see VNM Rationality Bounded rationality 19–21, 68–69, 171, 205 See bubbles Real estate, see bubbles Real options see options see valuation Recession xi, xiii, 13, 31–33, 233 Balance sheet induced ix, 29–30, 231, 233–234 Housing bubble related 14, 16, 17 RE (rational expectations), see expectations REE (rational expectations equilibrium), see expectations Reference Dependent 74, 78, 80, 81, 82, 84 Independent 73 Reflexivity, reflexive relations 61–63 See feedback See Self-fulfilling expectations Regret 72, 79, 80, 82, 84 And other emotions 82 Regulation see also deregulation government intervention Representativeness bias, see bias Reputational herding, see herding Residual value (RV), 109–112 see valuation Risk Aversion 37, 74–78, 165, 196, 215, 217 Repricing of risk 34–38 Connectivity and exposures 38–46 Economic instability and financial risk 39, 48–49, 51–54 Systemic risk and transmission mechanisms 3, 13, 36, 38–54, 175, 176, 231, 233 Runs Bank run 51–52, 176–178, 213 Creditor/depositor run 51 Collateral/margin 52 information induced 51–52 Russia 174, 179 Salience 70, 80, 84, 89 Schumpeter 48 287 Seasonal analysis 119 Securitization 15, 16, 18, 21, 233 Skewness 225, 226 Selective thinking, see bias Self-attribution, see bias Self-deception, see bias Self-fulfilling Economic contraction 37 Expectations, See expectations Prophecy 15, 131, 160, 170–171, 212 Price bubbles 170, 171, 188, 212 See bias See bubbles See reflexivity Semper Augustus bulbs Sensitivity analysis 118 See valuation Short-sale constraint 19–20, 193, 195, 196, 227, 228 Short-termist behavior 65–66 Signal Private 20, 182, 183, 194 Public 1, 20, 22, 57, 59, 63, 129, 132, 142, 166, 171, 182, 183, 185, 194, 195, 229 Signaling 57, 59, 137, 142, 147, 148, 228 Singapore 179 Skewness 225, 226 Slovakia Slovenia Smart money 24, 25, 26, 27, 28, 188, 227, 230 Social learning 14, 180–182 Sony 125 South America 8, See Latin America South Sea Act South Sea Bubble, See bubbles Sovereign xiii, 1, 2, 38–46, 54, 174, 176 S&P500 ix, xviii, 2, 34, 65, 123, 137, 149, 222, 225 Spain 1, 2, 8, Speculative Attacks 174, 232 Trading 12, 67–68, 167, 201, 212 see technical trading Spillover 173–175, 181 See contagion St Petersburg Paradox 74 Standard deviation 147, 148 Standard and Poor’s Index see S&P500 288 Subject Index Stealth Phase, see bubbles Stochastic Bubbles, see bubbles Oscillator see technical analysis Price 224 Pricing models 167, 202 Processes 202 Stock options, see options Subprime Mortgage crises xi Mortgage holders 87 Market 174 Securitization 15 Sunspots see bubble Support and resistance points, see technical analysis Systemic risk, see risk Taiwan 179 Technical analysis Average directional index (ADI) 147 Charts 132–137, 141–149 Aaron indicator 147–148 Bar chart ix, 133–136 Bollinger bands 129, 147–148 Candlestick chart ix, 129, 130, 133–136, 140, 152 Channel ix, 128, 131, 138, 139, 144 Chartism xiv, 128, 131 Cup and handle 142 Dead cat bounce 128 Double tops and bottoms 142–143 Flag 143–144 Gaps 140 Head and shoulders 141–142 Indicators, oscillators 128, 146–148 Line chart ix, 132, 133 Momentum indicator 146, 148 Moving averages (MA) ix, 128, 143–149, 152 Oscillators, see indicators Pennant 143–144 Point and figure chart (P&F) ix, xviii, 133, 136 Support and resistance points 138–140 Trend 137–138, 166–170 Triangles 143 Volume 140–141, 147–148 Wedge 143–144 Communal reinforcement 163 Continuation bias 163 Criticisms 130–131 Elliott waves viii, x, xvii, 130, 152–160 Criticisms 158–160 Fractal nature 156 Levels 155–156 Rules and guides 156–158 Extrapolation 163 Fibonacci 9, 149–152, 159–160 Arcs 151–152 Fans 152 Retracements 150–151 Time zones 152 Hindsight bias 163 History 129–130 Overconfidence, see bias Random prices 160–166 Selective thinking, see bias Self attribution, see bias Self deception 164, see bias Self-fulfilling prophecies 170–171 Trading 127–171 Versus fundamental analysis 128–129 Thailand xii, 188 Thomas theorem 60 Time discounting bias, see bias Too big to fail 4, 17, 39 Trade linkages, see linkages Transparency 17, 18, 24, 57, 86, 229 Treasury Bills (T bills) 14, 32 Trend line, see technical analysis Triangles, see technical analysis Tulip Mania, see Bubbles UK 23 see also England, Great Britain US Commodity Futures trading Commission (CFTC) xvii, 67–68 Valuation 106–126 Accounting 106, 107, 113, 121, 124 Detecting bubbles 96–100 Fundamentals of valuation 100–112 Accounting value 107 DCF value 107–109 Residual value 109–112 Methods to assess value 112–117 Book value 113 Liquidation value 113–114 p/e ratio 114–115 dividend yield 115 dividend discount method 115–116 discounted expectations 116 Subject Index 289 shareholder value creation 116–117 Components of fundamental analysis 117–120 Sensitivity analysis 118 Seasonal analysis 119 Nonfinancial analysis 119 Real options 119–120 Variance 214, 215, 216, 217, 221, 222, 226 Viceroy Bulb Trade viii, Volcker Rule 67, 68 Volume Contagion 190 Effects 131 Information 127–129 International capital flows 179 Trading volume xviii, 7, 9, 12, 16, 26, 27, 57, 67, 101, 199, 206, 218 Transaction volume 196, 218 see global flows see technical analysis Von Neumann–Morgenstern utility theorem xviii, 74–75 Wake up hypothesis 23, 178 Wall Street xii, 3, 65, 72, 73, 231 Wall Street Journal 129 Wedge, see technical analysis Windtrade 7 World Bank 173 Zero coupon bond 41 .. .Bubbles and Contagion in Financial Markets, Volume Bubbles and Contagion in Financial Markets, Volume An Integrative View Eva R Porras Independent scholar, Spain © Eva R Porras 2016... the interest of the financial industry itself: the practitioners, analysts, and researchers with an academic interest in investment banking, hedge funds, and risk management institutions and organizations... in learning more about bubbles and contagion will find this volume enlightening, including undergraduate, postgraduate, and PhD students in business administration, as well as those specializing