Thought of the Week – Bubbles and rumours
It feels odd to talk about stock market bubbles at a time when stock markets are not really trading at high valuations (at least not in Europe). But as we all know, while the stock market may be reasonably priced, individual stocks can still be in a bubble. One thing that drives share prices, particularly when they are in a bubble, is the narrative around the stock. And once narratives have taken over, there is fertile ground for rumours.
Tobias Herzing and Matthias Muck from the University of Bamberg in Germany examined how bubbles form in a laboratory and how rumours can influence these bubbles. The good thing about laboratory stock markets is that we can know for sure when a stock is in a bubble and share prices are far away from their fundamental value. We also know that in laboratory markets bubbles happen all the time and then crash as the experiment comes to its natural end.
What they found is interesting, because while 50% of their results are as expected, the other 50% are not. In their work, they differentiated between rumours that are circulating in the market that are false and rumours that are true. The first case are the classical rumours about stocks that are simply hyperbole or hearsay. The second are what many people wouldn’t call rumours but leaked information. These are situations where investors hear a rumour about a company’s dividends or earnings before this data is officially released. But once the data is released, it confirms the rumours that have been circulating in the market.
If we look at fake rumours first, the research shows what one would expect. If rumours spread, they can increase the bubble and push share prices even further away from fundamental value than before. The more these rumours spread, the more investors get on board with the bubble stock and the bubble grows bigger and lasts longer. Of course, if the rumour is discovered by the market to be false, share prices crash and the crash becomes more intense the more people have bought into the rumour and the bubble stock. False rumours create the same stock market action as a pump-and-dump market manipulation scheme.
But what happens if the rumour turns out to be true?
If the rumour turns out to be true, two things seem to happen. First, share prices get fundamental support, so there is less of a trigger to initiate a crash. Second, after the fact, some investors tend to sell some of their shareholdings to take profits. This drives share prices moderately lower and towards fair value. In essence, if a rumour turns out to be true, the bubble becomes smaller in a controlled way. The true rumour dampens the volatility of the share price and the size of the bubble.
Bottom line: True rumours are good for stocks, false rumours are bad for stocks. Now, all we have to do is figure out how to tell the two apart…
Thought of the Day features investment-related and economics-related musings that don’t necessarily have anything to do with current markets. They are designed to take a step back and think about the world a little bit differently. Feel free to share these thoughts with your colleagues whenever you find them interesting. If you have colleagues who would like to receive this publication please ask them to send an email to joachim.klement@liberum.com. This publication is free for everyone.
