Rational Bubbles in Individual Stock Prices and Implications for Investment Management

Abstract

Over the years, many stocks in emerging industries, with hindsight, have been overvalued. Stock prices relative to revenue, earnings, book values, or other measures often do not seem consistent with fundamental value. I illustrate a model in which the overvaluation of stocks is not necessarily due to excessively optimistic investors who create a bubble in stock prices, but could simply reflect uncertainty about which stocks will survive consolidation in the industry. I then discuss the implications of this for active investment management.