Estudios previos de vulnerabilidad en viticultura 40

States since the 1920s

Market bubbles and crashes in the US since the 1920s stock market bubble and crash are always tied together to discuss, as the occurrence of a market crash always follows the burst of a speculative bubble. Here, I briefly summarise prominent US stock market bubbles and crises between 1920 and 2015, and for those who are not interested, you can skip this subsection to the following section of hypothesis development. I start with the Wall Street Crash in the late 1920s which has been widely considered as one of the most devastating market crashes in US history, given its extent and the duration of its aftereffects. The 1920s, which is normally called the ‘Roaring Twenties’, were a golden period in which the US economy grew fluently and rapidly. Investors were infatuated with the enchanting returns from stock markets and thus traded stocks aggressively. Overconfidence drove investors to trade on the margin and pushed stock prices to unexpected highs. However, trading on the margin significantly increases the leverage level and introduces tremendous risks to investors. In other words, investors are left highly exposed when stocks prices fall. As a result, when stock prices started to decline, the vulnerable investors ‘dumped’ their shares, driving down

3_{This framework is constructed on the basis of Campbell (1987) proposition that stationarity}

between financial assets and their cash flows should be of the same order of integration, and, if they are both non-stationary in levels but stationary in first differences, the two series should be cointegrated.

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Investment Sentiment and Market Instability: An Investigation into Financial Bubbles and Crises

prices rapidly. Irrational exuberance inflated the speculative bubble and then burst it quickly. Researchers believe that prices were driven by the optimism/exuberance of investors, instead of economic fundamentals, during that time.

The next major stock market crisis emerged in 1987. On Monday, October 19th, 1987, the world’s major stock exchanges experienced a major crash on the same day. The contagious crash hit the markets around the world hard, leading to significant drops in market indexes. For example, almost all major stock markets fell by over 20%, and some lost over 60% (such as the New Zealand stock market). Numerous papers and commission reports have attempted to investigate what caused the crash. Malliaris and Urrutia (1992) noted that speculative activities in derivative markets, as well as existing speculative bubbles, accelerated the crash. After that, the 1990s High Technology Bubble has attracted attention to speculative transactions in stock markets. With the rapid growth in the usage and adoption of the Inter- net, the demand for high-tech companies increased sharply, and investors were eager to invest in the stocks of these companies, pushing up prices to extreme highs. Despite the irrational trading activities by individual investors, Griffin et al. (2011) and Brunnermeier and Nagel (2004) revealed that institutional investors ‘rode the bubble’ rather than attacked it. It has been documented that rational investors make significant contributions to speculative bubbles. The most recent crisis, the Global Financial Crisis of 2007 and 2008, is considered the worst financial crisis since the Great Depression of the 1930s. Originating from the US sub- prime mortgage market, the rapid expansion of the US subprime mortgage led to incredibly high default rates, giving rise to colossal bank failure. The housing and credit bubbles made the financial system increasingly fragile, and the bankruptcy of Lehman Brothers triggered market panic and fed investor fear. In addition, the collapse in people’s confidence in the subprime mortgage market spread to banks, stocks, and other financial markets, leading to widespread liquidations of assets and consequently causes contagious financial market crises.

5.3

Hypotheses Development

I construct my hypotheses based on a basic idea that during financial bubbles and crises, stock price changes follow a certain path-dependent dynamic, rather than a constant relationship. First, I predict that investor sentiment generates positive stock returns in the early and medium stages of bubbles. The intuition behind this proposition is that high buying pressure from both rational and irrational investors accelerates positive deviations of stock prices, resulting in higher stock returns. As argued by De Long et al. (1990), rational investors

5.3 Hypotheses Development 113

normally trade before irrationals, creating a buying signal for irrationals. Also, when investors experience euphoria from their investment, they tend to conduct more investments, which in turn attract more investments into the market. Hence, the increasing buying pressure pushes up stock prices and creates positive stock returns in the short run. Further, Abreu and Brunnermeier (2002, 2003) showed that rational investors typically choose to ride the bubble in the early stages, instead of attacking it, to achieve higher returns from irrationals before the ultimate mispricing correction. Hence, in the early stages of the bubble, an increase in investor sentiment produces positive future returns.

However, as the bubble persists, future stock returns may be dampened because of the intense selling pressure from both arbitrageurs and irrationals. In a sense, if rational arbitrageurs expect a price correction tomorrow, they sell immediately, thus creating a selling signal for irrational investors, which eventually leads to a fall in stock prices. Hence, in later periods of speculative bubbles (the long-term stage), stock returns are expected to drop because of the intense selling pressure.

Hypothesis 1. In bubbles, investor sentiment generates positive stock returns in the early and medium stages but negative returns in later periods.

Second, when the market falls into crises and recessions, because of the strong risk and loss aversion of investors, investors intend to liquidate assets as soon as possible in order to avoid further future losses when they see prices fall. Hence, the high selling pressure from liquidation drives down stock prices and reduces subsequent returns in the short run. In later periods of recessions, when the price is low enough, rational arbitrageurs intend to make enormous profits by ‘fishing the bottom’, that is purchasing undervalued stocks, as they believe stock prices will bounce back to equilibriums soon because of the mean-reverting property of stock returns. Hence, the purchasing activities from rationals improve investor sentiment and drive up stock prices, resulting in stronger buying pressures in the market and consequently higher future returns.

Hypothesis 2. In crisis and recessions, investor sentiment generates negative stock returns in the early stages but positive returns in later periods.

Third, when characterising the nature of bubbles and recessions on the basis of market volatility, I predict that the impact of investor sentiment on stock returns will be most significant when the market is most volatile and that the effect will be negative. In a general sense, excessive market volatility is always associated with frequent active trading activities. During extreme market conditions, excessive speculation (in bubbles) and rapid liquidation (in recessions) cause a growing number of active trading activities resulting in extra volatility.

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Investment Sentiment and Market Instability: An Investigation into Financial Bubbles and Crises

Empirical evidence indicated that in periods of financial bubbles and crises, market volatility is much higher than during stable periods.4

Assuming the excessive high volatility is caused by speculations, it means investors are willing to take on excessive risk and conduct more active trades. As excessive speculation pushes up security prices and lowers subsequent returns, a negative relationship between investor sentiment and security returns is expected in such periods (late periods of bubbles). On the other hand, when the extreme volatility comes from excessive liquidation during recessions, the high selling pressure drives down stock prices quickly and consequently reduces stock returns. Therefore, during periods of extreme volatility, a negative correlation between sentiment and security returns is hypothesised. However, this relationship becomes ambiguous in low volatility periods, as the trading behaviour in these periods is relatively rational.

Hypothesis 3. The impact of investor sentiment on stock returns is most significant when the market is most volatile, and the effect is negative.

Last, I also investigate the role of market returns on the formation of future investor sentiment. In particular, I predict that market returns impose a contemporaneously positive impact on investor sentiment. The positive effect is easy to understand as high market returns lead to optimistic expectations about the market resulting in high investor sentiment. Besides, the impact of market returns on investor sentiment should be contemporaneous rather than lagging as people frequently make immediate responses to stock price changes.

In a general sense, investors collect information from all available sources in the market to form their valuations. When no other information is available in the market, stock price, as an essential component of market information, directly affects people’s prediction on future stock prices, especially for irrational investors. Hence, it is predictable that any shock to stock market returns will also lead to shocks to investor sentiment. Second, this effect is expected to be stronger during recession periods relative to bubbles because of the overreaction of investors to (negative) stock price shocks during extreme market conditions as well as investors’ risk aversion. Empirical literature indicated that investors always misbehave and overreact to bad news but underreact to good news (Barberis et al., 1998; Daniel et al., 1998).5 _Intuitively,

when the market falls into recession, investors become increasingly vulnerable to negative

4_{Flood and Hodrick (1986, 1990) and Wu (1997) suggested that bubbles lead to excess volatility;}

while studies by Black (1976), Whaley (2000), Schwert (1989, 1990) and Schwert and Seguin (1990) found stock price volatility significantly increases during recessions.

5_{Other studies also indicated immediate and strong reactions from investors following the release}

of breaking news, such as first-day IPO abnormal returns and abnormal returns surrounding earnings announcements (Bartov et al., 2000; Cornelli et al., 2006; Kadiyala and Rau, 2004; Ljungqvist et al., 2006).

5.4 Models 115

news. In particular, investors usually choose to quickly liquidate their assets to avoid further losses due to their strong aversion to risk and potential losses.

Hypothesis 4. An increase in market returns lead to an contemporaneous increase in investor sentiment during financial bubbles and crises. This effect is more pronounced when the market is in crises (recessions) than when the market is in bubbles.

5.4

Models