July 3, 2003
When Emotions Guide Investors
HE stock market has come back from the dead, with the Standard & Poor's 500-stock index up 13 percent so far this year. Even the formerly moribund technology sector is reviving, with the Nasdaq showing a 26 percent return since January.
According to recent news reports, much of this renewed vigor is driven by retail investors. Is this a rational response to undervalued technology stocks, or the start of another bubble?
To gain some perspective, it is helpful to examine a recent post-mortem on the dot-com boom by two professors at New York University's Stern School of Business, Eli Ofek and Matthew Richardson. Their article, "DotCom Mania: The Rise and Fall of Internet Stock Prices," was published in the June 2003 issue of The Journal of Finance.
The authors' explanation for the bubble has two components. First, there were significant differences of opinion about the value of Internet stocks, with retail investors tending to be much more optimistic than insiders or institutions.
Second, there were significant restrictions on short-selling those stocks, a way of betting that they would decline. This prevented the pessimistic expectations from being incorporated in market prices. The result was that Internet stock prices were biased upward, with all-too-familiar consequences.
This story, or variations on it, is widely held to be a plausible explanation for the bubble. The contribution of Mr. Ofek and Mr. Richardson is to assemble a mass of detailed evidence that supports this analysis.
Start with short selling. When investors sell stocks short, they deposit an amount of money with their brokers, which earns interest. The interest rate is higher if shares of the stock that was sold short are readily available.
For Internet stocks this rate was substantially lower than for an average stock, suggesting that finding shares to sell short was more difficult. This low interest rate made the cost of selling Internet shares short significantly higher than for other shares.
Despite this, the percentage of Internet shares sold short was considerably higher than for ordinary shares. Apparently the short sellers were so confident that prices were overvalued that they were willing to pay the extra cost.
This leads to the second piece of the story: the claim that there were widely divergent views about the value of Internet stocks.
The most important piece of evidence for this claim comes from examining the difference between individual and institutional holdings of Internet stocks. There is a fairly large body of literature showing that individual investors are subject to behavioral biases, like overreliance on recent performance. Institutions, on the other hand, appear to be more rational.
The authors argue that dot-coms played a larger role in individual portfolios than in institutional portfolios. For example, as of March 2000, dot-coms were 4.4 percent of the overall market, but only 2.3 percent of pension fund holdings.
Further evidence comes from the authors' examination of large trades made between institutions. They find that Internet stock prices rose the most when the amount of such trading was low. This is consistent with the view that institutional investors tended to avoid Internet stocks, with the result that their prices were driven by excessively optimistic individuals.
As a test of their theory, Mr. Ofek and Mr. Richardson look at what happened to Internet stocks after they went public. During an initial offering, only about 15 to 20 percent of a company's shares are sold to the public. The underwriter typically requires the owners of the remaining shares to refrain from selling for a certain period, known as the "lock-up period."
At the end of this period, typically four to six months, insiders are free to sell.
Mr. Ofek and Mr. Richardson compared the change in price at the end of the lock-up period for Internet stocks with that for other stocks between 1998 and 2000. They found that Internet stocks dropped 4.1 percent in the five days up to and including the end of the lock-up, while the typical stock dropped 2.3 percent. They also demonstrated a large jump in volume after the lock-up, followed by a subsequent slow drift down in prices.
In the six months after lock-up expiration, the average Internet stock declined by 35 percent relative to a representative index of Internet stocks.
This finding casts some light on why the bubble finally burst in the spring of 2000. During this period, almost $300 billion worth of shares were unlocked, and a substantial number of insiders, venture capitalists, and early investors unloaded shares. By that time, the number of optimistic buyers willing to absorb these shares had been exhausted. Prices started falling, eventually turning even the optimists sour, and the bubble collapsed.
Much has been written about the betrayal of the small investor. But venture capitalists made no bones about the fact that they were selling. After all, that is what an initial offering is: insiders selling shares to outsiders.
Of course, there is no excuse for fraud and misrepresentation. But if those in the best position to know the long-term value of a stock were so eager to sell, one would think that would convey the message that dot-com valuations were too high. The market eventually got that message, but it took a long time.
What lesson can we draw from the Ofek-Richardson account about the current revival in tech stocks? It is that constraints on short-selling are still with us, so the market is still susceptible to irrational exuberance on the part of small investors.
Unfortunately, it is reportedly the most speculative stocks — biotech, Chinese Internet and penny stocks — that are showing the biggest price surges, and most of the interest appears to come from individuals. Analysts, whose views might be more representative of institutional investors, appear to be sitting on the sidelines.
If this pattern persists, it does not bode well for the current technology recovery.