The Stock Market: Fundamentally Sound or on the Bubble?

Adam M. Zaretsky

Reserve requirements are enshrined in introductory economics textbooks as one of the "tools," albeit a crude one, of monetary policy. Such regulations are understood to affect the banking system, and, ultimately, the economy by influencing the proportion of total assets that depositories hold as cash assets (either vault cash or balances with the Federal Reserve).

The cause of the seemingly unending rise in recent stock prices is of keen interest to economists. Although several explanations have been proffered, the underlying controversy splits economists into two groups: those who believe the rise is justified by market fundamentals and those who do not. Clearly separating the two groups, though, is easier said than done.

Calculating asset values from market fundamentals is a method that's well-grounded in economic theory. It is based on expectations about firm profits and relies on two assumptions: 1) that individual agents act rationally; and 2) that markets operate efficiently. Agents acting rationally implies that stockholders will adjust their expectations in response to new information; markets operating efficiently implies that they will immediately incorporate new information into market prices.

The concept of efficient markets also implies that arbitrage opportunities do not exist. They occur, for example, when two assets that are perfect substitutes have different prices. In such a case, an arbitrageur will buy the lower-priced one and sell the higher-priced one (pocketing the profit) until the prices are the same. However, as recently stated in The Economist,"The deepest insight of financial economics is that markets are fairly 'efficient' meaning that you can earn high returns only by taking big risks. There really is no free lunch."

Still, many economists believe that asset prices do move away from fundamentals sometimes. When this occurs, asset prices are believed to be driven by speculation, which is thought to cause speculative bubbles. Two of the most famous examples of these bubbles are the stock market crashes of 1929 and 1987. Even today, some economists maintain that the strong performance of the U.S. stock market in recent years is being caused by a bubble, rather than changing fundamentals.

Attempting to explain the existence of bubbles, some economists have proposed that they may, in fact, be rational. Suppose, for instance, investors realize that fundamentals are not driving stock prices and that a bubble exists. They know it will burst, but don't know when it will burst, only that it could burst today. Consequently, investors, by assuming a higher-than-normal risk, demand a higher return—a rational response. That said, there is no compelling evidence in the literature that rational bubbles exist.

More often than not, though, bubbles seem to form because a group psychology overcomes investors, who start making decisions based on a perceived frenzy. The housing market offers a good analogy. In a survey of California respondents in the late 1980s, 75 percent agreed with the statement: "Housing prices are booming. Unless I buy now, I won't be able to afford a home later." (Housing prices increased roughly 20 percent between 1987 and 1988 in many California cities.) Only 28 percent of Milwaukee survey respondents agreed with the same statement. (Housing prices were unchanged there.) What seems to matter, then, is whether investors think "hot" markets are fads, which contradicts economists' assumption of rational agents. In such cases, prices are high today only because investors believe that prices will be high tomorrow, not because the fundamentals support these levels.

The issue is not easily resolved. Perhaps what is most important, though, is that investors can recognize when fundamentals are no longer driving asset prices. Anecdotal evidence appears to suggest that currently they are not—at least in some market sectors. For researchers, though, anecdotes aren't enough. To those economists persuaded of their presence, bubbles challenge the foundations of economic theory because they contradict the underlying assumption of rational agents, upon which economic models are based. To those not persuaded of their presence, market phenomena like the Great Depression, the stock market crash of October 1987, and other apparent bubbles, demand and await persuasive explanations.

For more information, see his article in the April 1999 issue of the St. Louis Fed's Regional Economist.

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