1. Speculative Bubbles1 Keynes’ Beauty Contest: Speculative Price Bubbles in the Absence of Common Knowledge in Experimental Stock Markets Shin’ichi Hirota and Shyam Sunder University of Iowa Workshop, Dec 7, 2001

2. Speculative Bubbles2 Valuation of Securities Value = net present value of future cash flows Future is uncertain, value depends on investor beliefs about the future cash flows How far into the future? –From now to liquidation of the the security –From now to investment horizon (sale) –Sale price depends on beliefs of other investors about the cash flows after the sale –Return to formalization later

3. Speculative Bubbles3 Simple Example Investor A believes the net present value of cash flows from now on to be $100 (=fundamental value) Investor should buy below $100 and sell above What if A also believes that tomorrow, others will believe the net present value to be $150 Considering second order beliefs, it may not necessarily be best for A to sell at $110. A may be better off buying at that price, with the expectation of being able to sell at a higher price What is the best thing to do for an investor whose first and second order beliefs are not identical?

4. Speculative Bubbles4 Stories of Common Knowledge Assumption In a great deal of business modeling, common knowledge is routinely assumed What happens when it breaks down?

5. Speculative Bubbles5 Emperor Has No Clothes

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7. 7 Emperor’s Clothes The scoundrels made people believe that the clothes will be invisible only to the incompetent and the stupid People thought that others believed it Nobody wants to be seen as stupid or incompetent by others, lose his/her job Visibility of clothes was private, it was easy to fake seeing the clothes

8. Speculative Bubbles8 Emperor’s Clothes (Contd.) Scenario 1: Everyone was privately convinced of their incompetence, and cheered to deny it publicly Scenario 2: People did not believe they were incompetent just because they could see the naked emperor, but believed that others so believed, and cheered to avoid being seen as stupid

9. Speculative Bubbles9 What about the Child? The child did not know the link between visibility and competence Child was innocent, and said what he saw People know children to be innocent People knew that people knew this

10. Speculative Bubbles10 Stock Market Stock Market is like a newspaper beauty contest John Maynard Keynes, (1936)

11. Speculative Bubbles11 Newspaper Beauty Contest Which Face is the prettiest?

12. Speculative Bubbles12 Which face will they judge to be the prettiest?

13. Speculative Bubbles13 Which face will they judge to be the prettiest?

14. Speculative Bubbles14 LIFO Inventory Accounting If your inventory prices rise, and end-of- year inventory volume is stable or rising You can delay paying taxes (higher net present value of cash flows) But have to report lower income also Many firms don’t adopt LIFO Apprehension about stock market reaction (no empirical support)

15. Speculative Bubbles15 Agency Problem Agency problem: how to induce managers to maximize shareholder value (e.g., choose LIFO) Solution: Link managerial compensation to shareholder value Problem 2: Value manipulation Solution: Use market, not accounting, measures of value

16. Speculative Bubbles16 Value Maximizing Manager in an Efficient Market LIFO can increase NPV of cash flow But manager maximizes stock price What does manager believe about how stock prices are determined? Suppose manager believes that stock prices depend on income, not cash Then manager is rationally led to reject LIFO even if it saves cash for the firm

17. Speculative Bubbles17 Beliefs About Others’ Beliefs Common elements to the three stories about the emperor ‘ s clothes, stock market and LIFO Central role of what we believe about others, and about their beliefs

18. Speculative Bubbles18 Closing the Gap in Beliefs Is it possible for our first and higher order beliefs to differ? When they do differ, what does it take to get them to converge? Aumann (1976). Do they actually converge? Why or why not? When the beliefs of all around you are wrong, does it pay to hold on to the right beliefs? Fight them or join them? Prior experimental results What are the consequences for theories of bubbles?

19. Speculative Bubbles19 Bubbles in Economic History “Self-evident” bubbles: Galbraith, Kindleberger Econometric studies of long term recorded data: stock prices move sufficiently closely with dividend over the long run to reject bubbles Contemporary investors knew more than what the econometricians have in their data What changes in fundamentals can justify the 90 percent price drop during the Great Crash?

20. Speculative Bubbles20 Beliefs and Observation Theories of valuation are a function of beliefs In the field it is difficult enough to know the first order investor beliefs, and their diversity Second and higher order beliefs are practically out of reach In lab we might have a better, though still limited, chance to know beliefs, perhaps even open a gap between the first and higher order beliefs and observe their consequences under controlled conditions

21. Speculative Bubbles21 Models of Bubbles Tirole (1082, 1985): bubbles grow at discount rate, no prediction about levels First order beliefs D t i ≠ D t ij (second order beliefs) Investor need not be irrational in decisions or beliefs, and need not believe the others to be irrational. Aumann: common knowledge priors imply common knowledge posteriors

22. Speculative Bubbles22 Professional Security Analysis Multi-billion dollar information intermediary industry in U.S. alone Typical report has current market price compared to what the analyst predicts the future price to be, and what the analyst believes the firm to be worth If investor beliefs were common knowledge, there will be no rationale for such beliefs Bubbles generated by gap between the first and second order beliefs do not depend on investor heterogeneity

23. Speculative Bubbles23 Finite Maturity Securities

24. Speculative Bubbles24 Finite Maturity Securities Cells C and D (sessions 3 and 4) All dividends except terminal dividends are zero Equilibrium price is constant through the 15 sessions By design, second order beliefs have the chance of being higher than the first order beliefs Expect to observe bubbles as late as period T-1 in Cell C Expect the bubble to crash in the last period (Figure B)

25. Speculative Bubbles25 Indefinite Maturity Securities

26. Speculative Bubbles26 Indefinite Maturity Securities Cells A and B All dividend except liquidation dividend are zero Session does, and is expected to end before liquidation Terminal payoff by endogenous prediction game (see Figure A for price path)

27. Speculative Bubbles27 Experimental Design Double auction market for multiple units of a single security that pays single liquidating dividend Multiple trading periods (3 minutes each) Each investor endowed with 10 shares, 10,000 points in “cash” Liquidation by dividend or predicted price Predictors knew the rules, no endowments, no ability to trade, could watch trading, knew the range of terminal dividends

28. Speculative Bubbles28 Experimental Design Final Payoff Predicted PriceDividend Gap between first and second order beliefs YesCell A: Session 1Cell C: Session 3 NoCell B: Session 2Cell D:

29. Speculative Bubbles29 Experimental Parameters

30. Speculative Bubbles30 Trading Screen

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32. Speculative Bubbles32 Cell A (Session 1) Endogenous, gap Small bubble (10 percent) Highly stable No crash High correspondence between actual and predicted prices Efficient security transfer late but not early

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34. Speculative Bubbles34 Cell B (Session 2) Endogenous, no gap Huge bubble, well above second order belief limits Highly stable Did not crash Allocations suggest that terminal dividends ceased to play any important role in driving trading, largely driven by prediction

35. Speculative Bubbles35 Tentative Conjectures Conjecture 1: In absence of exogenously specified terminal dividend, price bubbles can form, and persist through the end of a session.

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37. Speculative Bubbles37 Cell C (Session 3) Exegenous termination, gap Large bubble, prices above upper limit of second order beliefs Bubble burst earlier than last period Error by one trader (forgot terminal dividend)

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39. Speculative Bubbles39 Cell D (session 4) Exogenous termination, no gap No bubble Fundamental price and allocations

40. Speculative Bubbles40 Tentative Conjectures Conjecture 2: Even with exogenous terminal dividend and known horizon, bubbles can form when there is a gap between first and second order beliefs. Conjecture 3: In the presence of exogenously specified terminal dividend, end-of-the-session prices converge to the equilibrium level determined by such dividends.

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42. Speculative Bubbles42 Results A: Gap, Endogenous Termination

43. Speculative Bubbles43 Discussion Shiller: prices too volatile French and Roll: Market trading itself creates volatility (possibly through formation of second order beliefs?) Significant part of market returns realized as capital gains, not dividends Valuation models should incorporate second order beliefs

44. Speculative Bubbles44 Discussion Stock prices can stabilize far from fundamental price levels Price predictions can simply reinforce deviations from fundamentals In a market dominated by “capital gains” traders, price can be decoupled from fundamentals Consistent with gap between first and higher order beliefs generating price bubbles

45. Speculative Bubbles45 Bubbles and Rationality Lei, Noussair and Plott: observe bubbles in absence of speculative trading Lack of understanding by subjects of the market structure, task, opportunities Lack of correspondence between the intended and subjective experimental environment Difficult to determine the correspondence Is lack of understanding “irrational?’ Need get inside “irrationality.”

46. Speculative Bubbles46 Candidates to be Examines Gap between intended and subjective experimental environment We tried this in a fifth session; observed many errors in spite of better instructions Link between uncertainty and bubbles Link between low dividend securities (larger duration) and bubbles

47. Speculative Bubbles47 Thank You The paper will be available on http://www.som.yale.edu/faculty/sunder/res earchhttp://www.som.yale.edu/faculty/sunder/res earch My email is shyam.sunder@yale.edu

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51. Speculative Bubbles51 Financial Analysis, Trading Volume and Bubbles Mostly fundamental analysis, assumes common knowledge Assumption relaxed by convenience Models of price bubbles based on relaxing the common knowledge assumption Trading volume models based on diverse beliefs

52. Speculative Bubbles52 Models of Weakening Common Knowledge Assumption Efficient markets may fail to discipline managers (Amershi and Sunder) Alternatives to fundamental valuation model, even technical models Models of corporate disclosure (unraveling does not work in practice) Understanding results of ultimatum games

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54. Speculative Bubbles54 Levels of Analysis

55. Speculative Bubbles55 Thank You The paper, and slides will be available next week at http://www.som.yale.edu/faculty/sunder/res earch.html or email to shyam.sunder@yale.edu

56. Speculative Bubbles56 The purpose of our study Explore why the price bubble occurs in stock markets Investor’s belief on other’s belief Stock market experiments

57. Speculative Bubbles57 Stock market bubble in the real world Internet Bubble –e.g. Yahoo – 10$ now, $250 in the peak Japan late 80’s –e.g. Nikkei 225 Average – 10,000 yen now, 40, 000 yen in the peak Must be bubbles –Why bubbles occur

58. Speculative Bubbles58 Investor should expect... Infinitely lived investor –Discounted value of future dividends Finite horizon investor –Resale price –Others’ valuation –Others’ expectation for the future Future dividends Future price –

59. Speculative Bubbles59 If he believes that … Others will believe high future dividends or high future price, What should he do? –Even if he does not believe high future dividends or high future price.

60. Speculative Bubbles60 If every investor believes that Others will believe high future dividends or high future price, What will happen? –Even if every investor himself does not believe high future dividends or high future price

61. Speculative Bubbles61 Stock prices are determined by –not investors’ own beliefs (first-order-beliefs) –but investors’ beliefs on others’ beliefs (second-order-beliefs) Any Price can be observed depending on second-order-beliefs

62. Speculative Bubbles62 Bubbles Price  Fundamental Value –Price Second-order-belief –Fundamental Value First-order-belief Second-order-belief  First-order-belief

63. Speculative Bubbles63 Keynes Newspaper beauty contests –Well-known and popular story –True in real world? How to verify? –Fundamental value is unobservable –Gap is unobservable

64. Speculative Bubbles64 Experimental Study Laboratory –Fundamental value is observable –Create the gap between FOB and SOB –See the effect of the gap on the stock price Experimental Results –Bubbles occurred due to the gap –Keynes is right!

65. Speculative Bubbles65 Experimental Markets Stock market in the laboratory Trade a single stock 15 (12) periods of 3 minutes each Stocks has a life during the experiment

66. Speculative Bubbles66 How to create the gap between FOB and SOB Each investor knows dividends (FOB) But… SOB may be different from FOB [Market 1] –Dividends may not be received in the investment life. Dividends are paid only if the session lasts for 30 periods The subjects can easily guess that the session ends earlier The stock at the last period is evaluated at the predicted price of the next period They have to expect what the market expects the price

67. Speculative Bubbles67 How to create the gap between FOB and SOB (continued) [Market 2] –15 periods. Dividends are paid at the end of Period 15. –Each knows his dividend, but does not know others’ dividends Investors draws the dividend card Private information The dividend range is informed to everyone Investors have to guess others’ dividends, i.e., others’ valuation of the stock.

68. Speculative Bubbles68 Investrors and Predictors Investors –10 stocks, 10,000 cash –trade stocks using caplab TM system –receive money depending on profits Predictors –predict the next period’s price –receive money depending on the accuracy

69. Speculative Bubbles69 Conducted Experiments what, who, where, when 2 sessions for Market 1 (Session 1, 2) 1 session for Market 2 (Session 3) Yale university, undergraduate students Yale School of Management, B-74 Room September 21, 29, 30, 2001

70. Speculative Bubbles70 Conclusion (from preliminary experimental results) The investors’ beliefs on other’s belief (SOB) significantly affect the stock prices. The gap between FOB and SOB seems to create bubbles in stock markets.