Friday, September 15, 2017

Is A Bubble A Bubble If You Can See It's A Bubble?

From time to time the usually perspicacious commentators at FT Alphaville will say something that just ain't so.

This is especially true when Izabella Kaminska is writing about cryptocurrencies—which I sometimes think she does as much to get a rise from the cheap seats as she does to explicate a point or principle of crypto.

Here's an example of an ahistorical comment which is in response to Ms. K's post "Crypto tethers as the new eurodollars":

Having followed much of the FT's extensive coverage on crypto (as well as the Wall Street Journal, Forbes, CNBC etc) and from reading hundreds of comments from readers, it is clear to me that the overwhelming majority of observers wholeheartedly believe that Bitcoin is a bubble.
It's ironic that this defies one of the key characteristics of other financial bubbles in history; the naysayers get shouted down by the majority which, in turn, permits the mania to propagate further.

It's that 'shouted down' bit that jumps out at one. That is not the way financial manias propagate. Naysayers get ignored rather than shouted down.
All this is lead-in to a repost from February 2012 whose linked paper gets into the nature of bubbles and directly addresses the awareness/self-awareness question:

Prop Trading the South Sea Bubble: Hoare's Bank 1720
I've mentioned the archives at Hoare's Bank a few times, firstly, I believe, in "South Sea Bubble Survivor Says Dismantle RBS Along With Lloyds":

...*From deep in the link-vault comes a tiny treasure, an analysis of Hoare's trading during the South Sea bubble (15 page PDF):

Riding the South Sea Bubble
This paper presents a case study of a well-informed investor in the South Sea bubble. We argue that Hoare’s Bank, a fledgling West End London bank, knew that a bubble was in progress and nonetheless invested in the stock: it was profitable to “ride the bubble.” Using a unique dataset on daily trades, we show that this sophisticated investor was not constrained by such institutional factors as restrictions on short sales or agency problems....MORE 
The bank has opened their records to academics and Temin and Voth have taken full advantage.
Along with the above they published "Banking as an emerging technology: Hoare’s Bank, 1702–1742" in Financial History Review and "Private borrowing during the financial revolution: Hoare’s Bank and its customers, 1702–24" in Economic History Review.

It's Riding the South Sea Bubble that really stands out though and is the 'tiny treasure'.

Yesterday, as I was putting "The World's First Stock Exchange (and first bear raid, first dividend, first equity derivatives...)" together I wanted to refer to RtSSB and did a quick search of the blog.
The link was broken.

The entire original purpose of this blog was to give me a database of things that caught my interest during the trading day. Hosted on Google's servers. Searchable by the Goog's algos (or anyone else).
And the damn link was broken. So I had to replace it.

And I re-read the whole 15 page paper, starting with:
What allows asset price bubbles to inflate? The recent rise and fall of technology stocks have led many to argue that wide swings in asset prices are largely driven by herd behavior among investors. Robert J. Shiller (2000) emphasized that “irrational exuberance” raised stock prices above their fundamental values in the 1990s. Others, however, have pointed to structural features of the stock market, such as lock-up provisions for IPOs, analysts’ advice, strategic interactions between investors, and the uncertainties surrounding Internet technology, as causes of the recent bubble. We use a historical example to ask which of these explanations is most apt, with the potential to shed light on other important episodes of market overvaluation.

We examine one of the most famous and dramatic episodes in the history of speculation, the South Sea bubble. Data on the daily trading behavior of a goldsmith bank—Hoare’s—allow us to examine competing explanations for how bubbles can inflate.

While many investors, including Isaac Newton, lost substantially in 1720, Hoare’s made a profit of over £28,000, a great deal of money at a time when £200 was a comfortable annual income for a middle-class family (John Carswell, 1993). The behavior of a single knowledgeable investor can tell us much about the nature of bubbles and investors during periods of substantial mispricing. The bank did not profit simply by chance. It “rode the bubble” for an extended period while giving numerous indications that it believed the stock to be overvalued. Short-selling constraints and the difficulties of arbitrage that have been emphasized in recent work on the dot-com mania cannot explain the South Sea bubble. A zero-investment constraint, if it existed, did not bind market participants like Hoare’s. Perverse incentive effects arising from delegated investment management highlighted in recent work on mutual funds and hedge funds were not at work. We infer that the need for coordination in attacking the South Sea bubble was the key to allowing it to inflate to such an extreme extent, in line with recent theoretical work by Dilip Abreu and Markus Brunnermeier (2003).

There is a rich body of earlier research on the emergence of bubbles. The efficient markets hypothesis rules out substantial mispricing (Eugene F. Fama, 1965). The same conclusion emerges from no-trade theorems under asymmetric information, as well as from backward induction in finite horizon models (Manuel Santos and Michael Woodford, 1997; Jean Tirole, 1982). Famous historical episodes like the South Sea bubble, the tulip mania, and the Mississippi speculation are given as examples of markets functioning reasonably well under uncertainty (Peter M. Garber, 2000). Recent theoretical and empirical work, however, suggests that bubbles can inflate even if there are large numbers of highly capitalized, rational investors....
And I thought "sweet".

The two most important parts of the paper "II. Hoare’s Trading Performance" and "III. Causes of Success" are definitely worth a couple minutes. Here's the link. (also replaced in the original post).