Econ 319 – Lecture 8
October 2, 2012
End of Section 2
C. Speculative Cycle and “Fundamentals”
Expected PV of future stream of dividends
Expected future sale price
2. But what if expectations become “too” optimistic?
Widespread optimism rising prices capital gains
o If ONE person is optimistic, they will buy a whole bunch of shares, but will not
influence the market. But If there is widespread optimism, it leads to rising share
prices (people are all optimistic about the future), generates capital gains (anyone
who bought before sees share values go up – capital gains justify optimism)
justifies the optimism
o Prices “deviate from fundamentals”
Why are people paying a certain price for it? They are seeing the equation
and feel optimistic
o But aren’t expectations part of “fundamentals”
3. “Bubbles” and crashes
What is a bubble? – Distribution of the perceived “fundamental value” of a specific share
There is never going to be an agreement on the right or “fundamental” price
They agree that there is a range – fair value. Anything to the right = too high, to left = too low We will never know the true value. Someone will think that this is at the right value; some will
think it’s cheap, and some will think it’s too high. Is this a bubble? YES. Most people mean that
the current market price is higher than most people think the fundamental value is.
People ask today: Is there a bubble in the Canadian housing markets?
- Everyone has different opinions on where the market price should be
Is the market price ever here? (Left of fair value)
- Next market crash
- When people sell their assets, leads to panic, more selling, etc = panic selling
There will always be disagreement and distribution, so it is never clear to say “that share price is
in a bubble situation” – probabilistic statement
D. Cause or Effect of Business Cycles?
- Do changes in the stock market lead to changes in the economy? Or vice versa?
- A lot can happen in the economy and appear to be more or less disconnected from the
o Stock market is more volatile (changing daily)
o Real economy = changing more slowly, except in bizarre times!
o But it is NOT a side show!
- Changes in stock market prices reflect economic changes
- Current and future
- (Stock markets are forward looking)
i. Looking at future stream of profits in the indefinite future because assets
are long lived assets
- Changes in stock market prices CAUSES changes in aggregate demand
i. Clear in dramatic moments!
ii. Stock markets rise and fall daily
- Wealth effects - Optimism/confidence
- Ease of financing
So is it a crucial marketplace or a pointless casino?
Market efficiency – a term that is used and abused…
- In last 3 years, non-economists sneer at economists because they talk about
- Means that markets don’t make mistakes. Prices embody all information or
markets tend to work perfectly without failure
- Markets convey all info immediately
i. No economist ACTUALLY believes in that meaning
- What they do believe in is: idea that markets, especially financial markets, are
good at processing information
Three things to read about stock markets and bubbles:
1. “A Beginner’s Guide to the Stock Market”
2. “What the S&P/TSX Really Measures”
3. R. Shiller, Chapter 26, “Speculative Bubbles and Their Costs to Society”
a. Written to explain finance and why it is an important part of achieving a good
society where income in reasonably distributed, etc.
Crises in “Ancient” History
- Three important readings:
o Galbraith’s book – short history of financial euphoria
o Johnson and Kwak, 13 bankers
o George Granthum paper
- John Kenneth Galbraith
o Canadian, trained at OAC (U of Guelph)
o Child of the depression
o Worked in Harvard 1936-
o Not a “mainstream” economist
o Died 2006
o Quintessential American Liberal (centre left of political spectrum)