Column: Picking asset price bubbles

Oct 15 2013, 03:51 IST
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SummaryDifficult to conjecture asset price in the short term, but can be guessed well in the long run

It is not surprising that, in the aftermath of the financial crisis of 2007-08, the Nobel Prize for Economics has been awarded to economists who have made significant contributions in the area of asset prices. The names are familiar—Robert J Shiller (student of behavioural economics), Lars Peter Hansen (expert in building models) and Eugene F Fama (a follower of efficient markets hypothesis). The decision was not surprising, as Shiller’s name was the foremost in the list of probable awardees. Their concern was over assets, their prices and possible bubbles.

Broadly speaking, their contribution goes this way. When we look at asset prices, be it stocks or bonds, it is difficult to conjecture their price movements in the short run, which could be, say, a few weeks or even months, though the same can be guessed well in the long run, which could be 3 or 5 years. This makes sense when we look at our own stock market. On a daily basis, we cannot make guesses because there are new bits of information coming in every now and then (Fama), which guides prices. RBI announcement of new banks can push up prices of bank scrips while an impasse on mining laws in Parliament can push back the stocks of mining and related companies.

Therefore, predictability is the issue. If all players knew the price and start buying the stock, the price would automatically move up until such time that it becomes less attractive. The unpredictable pattern is more often the case and the movements are random, and hence it is said that stock prices follow a random walk. Therefore, Fama argued that today’s price is no guide to tomorrow—which is seen in our own stock price movements, where the Sensex or Nifty yo-yo on a daily basis being affected more by distant effects such as the Dow Jones or Fed actions in the interim period.

In fact, an interesting outcome of Fama’s work is that lots of the information we are talking of have an impact on just one day. A dividend announcement or a stock split will affect the share price on the day and move back to the trend line subsequently. This also appears to be the case with Indian markets, where the Sensex moves up or down to news for a single day and then gets back to the trend, which has been upwards. Therefore, to put the theory into

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