'The stock market's movements are generally consistent with rational behaviour by investors. There is no need to invoke fads, animal spirits, or irrational exuberance to understand the movements of the market.' Discuss in relation to the information technology bubble and its collapse. Introduction In a perfectly efficient market, it is assumed that all investors have access to all available information of future stock prices, dividend payoffs, inflation rates, interest rates and all other economic factors that affect the present prices of stocks. All investors are perfectly rational and choose to invest in stocks which will have a positive payoff.

Therefore, all financial assets must always be priced correctly. Any apparent deviations from the correct pricing for stocks, according to the efficient market theory, must be an illusion, and no gains can be made from arbitrage. In short, all stock prices should reflect genuine and fundamental information about the value of the stock in question. There would be no need to explain changes in price by invoking fads, animal spirits and irrational exuberance. By this theory, stock prices corrected for a time trend should follow a random walk through time, as any changes are only due to new information, which by definition cannot be predicted in previous periods.

Most empirical studies using data on a stock market to test whether stock prices follow a random walk has been statistically rejected. Also, from a non-specialist point of view, it is easy to find examples in history where stock prices seemed not to have followed a random walk, the dotcom boom of the late 90 s being an often-quoted example. The idea of an efficient market is very natural. From observation, it doesn't seem easy to make lots of money by buying low and selling high, just as many investors fail on the stock market as succeed. If certain 'smart' investors can find ways to make profits on the stock market by buying low and selling high, then, according to theory, they will drive asset prices to their true values; by buying under-priced assets they will drive up those prices, by selling over-priced assets they will drive down those prices. Also, if there were substantial mis pricing of assets, the 'smart' investors should make lots of money, hence increasing their influence on the market and their ability to eliminate.

By this standard, it would seem that there should be no cases in history where stock prices have raised (or fell) to a point where they can no longer be explained by rational causes, at all times, the prices of stocks should be a fair reflection of its true fundamental value. During the dotcom boom of the late 90 s, where prices raised to an unprecedented high in the US stock market, according to efficient market theory, there should have been economic factors which induced these inflated prices, and there should have been true value to back these prices. However, during that time, basic economic indicators did not come close to increasing by as much as shown in the stock market. For example, corporate profits only rose by less than 60%. By these figures, there seems to be little rational as to why stock prices were so high. Indeed, the collapse of the US stock market in the early 00 s indicated that stock prices were indeed to high, and the stock market could no longer support itself.

To investigate whether irrational behaviour, to some extent, helped to cause the IT bubble, I will begin by looking at possible rational explanations and whether they alone can explain the dotcom boom and bust. Then, I will see how irrational behaviour could have contributed. Some Simple Background Facts The mainstream introduction of the Internet in 1997 can be compared to the introduction of televisions and personal computers in the amount of influence it has over everyday life. Because of the immediate impressions it makes, people pick up very quickly on the huge impact it will have on commerce.

As well as a tool to improve productivity of existing conventional companies, the Internet also made possible the existence of what are now large corporations based solely in the World Wide Web. From the mid 90 s, shares in such companies became incredibly popular, and helped to hyper-inflate the prices of their shares, and the whole stock market. With the flotation of each new company, investors saw increases in the price of shares by hundred-folds; the most notable case being Globe. com, who saw an increase from 97 cents to $9 in one day. There are some examples of financial prices that cannot possibly seem to be right. For example, e Toys, an Internet firm specializing in toys, had a stock value of $8 billion, which is greater than the $6 billion value of the established Toys R Us.

e Toys saw sales of $30 millions, while Toys R Us saw sales of $11. 2 billion, and e Toys made a loss whereas Toys R Us saw a profit of $376 million. It would be unreasonable to claim, in the light of these facts, that there was not a speculative bubble associated with the Internet boom. Rational Behaviour and the Dotcom Bubble It is true that at least many investors, most of the time, chose to invest in Internet companies because given their beliefs, they saw those companies as the ones that will maximis e their earnings, through dividends and the final value of the stock.

Are there indications that these earnings justified the prices of the stocks? There were unusually high levels of stock earnings between 1990 and 2000. Real earnings, according to Standard and Poor's Composite Earnings, more than doubled in the five years prior to 1997, a growth rate not seen for nearly 50 years. Another way to view this is to look at the price-earning ratio. This is a good measure of how 'expensive the market is relative to an objective measure of the ability of corporations to earn profits'. Historically, there is a negative relationship between price-earning ratios and returns to dividends. If a share led to lower dividends, it would seem that a lower investment return should be expected, and vice versa.

Returns to dividends are seen as a reliable return to stocks, rather than the less predictable capital gains. If the efficient market theory holds, the price-earning ratio should be fairly consistent. However, even given the large increase in earning growth, by 1997, the ratio has reached levels not seen since 1929 after the bull market of the 20 s. The tumble of this ratio after 1929 is reflected in the tumble during the early 00 s.

It would seem unreasonable to propose that this increase in earning growths can explain high stock price levels alone. It has been claimed that there is often a connection between real dividend movements and the real stock price movements. Front and Obst feld suggested, in an 'intrinsic bubble' model, that prices respond to dividend movements in a rational, albeit exaggerated, fashion. Stock prices overreact to dividends, but 'there are no profit opportunities to trading to take advantage of this overreaction'. Empirically, it is not true that dividends and stock prices correspond well. Indeed, dividend returns did not increase by as much as prices during the 90 s.

In fact, some of the more 'desirable's hares in dotcom companies paid significantly less than their brick and mortar equivalent. Also, theoretically, it is often that the underlying cause for any observed coordination between prices and dividends are in fact the same factors. Managers of companies choose the rate at which dividends are paid out, but managers are just another portion of the investing public, and they will use any feelings of optimism to influence their decisions, so, concurrent dividends and prices are not necessarily only a manifestation of a rational market. An alternative approach to apply rationality to the stock market boom of the late 90 s is by accepting a learning process made by investors. If, in the early 90 s, the investing public learns that the long term value of the stock market was actually greater than its present value, and investing in stocks and shares will lead to a greater return than other assets (such as bonds), then that will drive up prices for stocks.

Basically, we assume that the market was inefficient, but learning from the public leads to a more efficient market. This learning could be attributed to greater media coverage. Shiller argues that there is no evidence that during the 90 s, or indeed any significant period, had stocks consistently performed better than bonds, and so there was no information for the public to learn. Irrational Exuberance and the Dotcom Bubble It is almost impossible to distil the factors that contributed to the dotcom bubble. I think there at least some of the causes must originate from a rational framework, but I also think that they alone are not convincing enough; one has to invoke some irrational exuberance in order to explain the bullish stock market during the late 90 s. Psychological experience shows that there are patterns of behaviour in the stock market which cannot be contributed to ignorance, but which nevertheless cannot be classed as rational behaviour.

People tend to use past prices as anchors for predicting present prices, so when certain shares are seen as valuable, people tend to regard them as increasing in value. This obviously creates a feedback loop, leading to the bubbles. Also, herd behaviour can dictate how an individual will react. People tend to follow their contemporaries, because we all find it difficult to doubt something in which many others believe. Again, this creates the feedback loop that can lead to speculative bubbles..