Dr. David P. EchevarriaAll Rights Reserved1 Observations on Chapter 9 A Brief History Of Investment And Speculation

Dr. David P. EchevarriaAll Rights Reserved2 Student Learning Objectives Historical Background Investing and Speculating Fundamental Nature of the Market Speculative Bubbles Examined Rationality and Investor Behavior

Dr. David P. EchevarriaAll Rights Reserved3 Historical Background Legitimate investing has a short long history – Two problems; US-based stock investing history is relatively short – partly a function of increased distribution wealth unrestricted – partly the results of unrestricted economic expansion Europe and the Far East have longer histories – first international bank dates to the13th century AD complete with passwords and international exchange of currencies. – Hedging activity dates to the 11th century – Speculation in commodities predates the common era

Dr. David P. EchevarriaAll Rights Reserved4 Investing and Speculating Investing Speculating InvestingInvesting and Speculating are difficult to define. We define Investing as the rational act of an individual or institution using the best available information in order to earn a reasonable rate of return based on the estimate of risk involved. SpeculatingWe define Speculating as the rational act of an individual or institution using the best available information in order to earn a reasonable rate of return based on the estimate of risk involved. investor speculatorIf you win - you’re a wise investor, if you lose - you’re foolish speculator.

Dr. David P. EchevarriaAll Rights Reserved5 Fundamental Nature of “the Market” expectationsinformation[Security] markets are everywhere and always an expectations and information phenomena. –Expectations future state of nature –Expectations arise from a variety of sources and motives. They are, in the first blush, the best estimate of the future state of nature. –[New] Information –[New] Information arrives after the time that expectations are formed to either confirm, negate or cause modification of the original expectations.

Dr. David P. EchevarriaAll Rights Reserved6 Speculative Bubbles Speculative bubblesSpeculative bubbles are most likely to form when expectations are unreasonable: They are based on incomplete or erroneous estimates of the future states of nature. emotionsIncomplete or erroneous estimates are largely the result of investor emotions affecting or displacing the analytical process.

Dr. David P. EchevarriaAll Rights Reserved7 Speculative Bubbles Speculative bubbles manifest themselves as rapid rises in prices in a relatively short time. –Price increases accelerate as late comers seek to get on the bandwagon; a financial feeding frenzy! motivationssimple greed –Late comers motivations may be simple greed. The passage of time brings new information –When new information and expectations are not in sync - price adjustments result. –Intensity of price adjustment depends on conditions.

Dr. David P. EchevarriaAll Rights Reserved8 European Speculative Bubbles Tulip Mania: –interest begins as a fashion statement –proceeds to extensive commercial investment –competition/demand drives up prices –insufficient commerce - prices collapse –Holland imperial plans caught between those of England, Spain, and France. –Holland is still an important player in the world tulip industry.

Dr. David P. EchevarriaAll Rights Reserved9 European Speculative Bubbles South Sea Bubble 1720 trading –What happens when a trading enterprise gets involved in government financial dealings. equity for debt swaps –An early example of equity for debt swaps. Ponzi –Venture became a Ponzi-like stock scheme –Which ended when insider selling was exposed –Was the South Sea Company a true speculative bubble or a stock swindle?

Dr. David P. EchevarriaAll Rights Reserved10 American Speculative Bubbles The Great Crash: 1929 –Extensive stock price manipulation –Stock frauds –lack of regulatory oversight body –Illegal bank activity –Public gullibility (naivete) –Conditions for a speculative bubble? –Is every run up in stock prices a spec-bubble?

Dr. David P. EchevarriaAll Rights Reserved11 The Crash of % p.a. 42% p.a. - 49% p.a. DJIA weekly close

Dr. David P. EchevarriaAll Rights Reserved12 American Speculative Bubbles Other Alleged Speculative Bubbles –Electronics Boom: 1950’s and 1960’s Is it over or just transformed? –Conglomerates: 1960’s (11% p.a. average) Ignorance of core competencies Failure to innovate Failure to adopt new technologies –Nifty Fifty: 1970’s Single decision stocks Excessive demand concentration

Dr. David P. EchevarriaAll Rights Reserved13 American Speculative Bubbles 1980’s –Heavy capital investments to improve efficiency, reduce costs - improved profitability merger/acquisition mania –Slow-down of the merger/acquisition mania. –PC begins to make impact by end of the decade –October many reasons - bottom line - market recovered losses within 24 months. –Fed role in adverting financial meltdown is key

Dr. David P. EchevarriaAll Rights Reserved14 Meltdown Monday: October 19, 1987 DJIA - Daily close % p.a.

Dr. David P. EchevarriaAll Rights Reserved15 American Speculative Bubbles 1990’s –Collapse of the Soviet Government –Opening DOD ARPANET to civilian use (1980’s) - birth of the Internet –Increasing PC power reduces dominance of main frame computers - several major companies go out of business. internet infrastructure –Demand for data/information/utility results in explosive growth of internet infrastructure. –A spec-bubble? Too early to tell.

Dr. David P. EchevarriaAll Rights Reserved16 Some Observations The average growth rate in the DJIA during the 1950’s and 1960’s was approximately 11% per annum. The Market did little during the 1970’s due to two oil shocks. The DJIA grew at about 13% per annum in the 1980’s The DJIA has been growing at more than 20% p.a. during the last half of the 1990’s.

Dr. David P. EchevarriaAll Rights Reserved17 Japan as a Speculative Bubble Japanese Economic Expansion –Driven by investment in world class facilities –Yen continues to climb in value relative to other OECD currencies. –Reaction in US and Europe to Japan, Inc. Japanese move production to US and Europe Large production overhangs in Japan Intense capital investment in US and Europe spells end for J-juggernaut Market collapse recognition of new realities.

Dr. David P. EchevarriaAll Rights Reserved18 Some Questions about Bubbles Why do bubbles occur? Are bubbles inevitable? Can bubbles be predicted and thus avoided? Can, and should, regulators do anything to prevent bubbles?