Irrational Market Research Articles

Rational vs. irrational firm's optimal price and social welfare

This paper builds three models to explore the value of market irrationality when consumer's expectations of product quality and product availability follow two distribution functions. A benchmark model with rational expectations is set; two models with irrational expectations and social welfare discussion follow it. Three contributions have been made in this paper: 1) obtain the firm's optimal decisions in rational and irrational market environments; 2) compare results in the rational case and in the irrational case, and further point relationships of these optimal results; 3) prove that social benefits belong to both firm and consumers in the irrational case (this conclusion is different from that in the rational case) and shed light on ways to improve social welfare under consumer irrational expectations.

Rational vs. irrational firm's optimal price and social welfare

This paper builds three models to explore the value of market irrationality when consumer's expectations of product quality and product availability follow two distribution functions. A benchmark model with rational expectations is set; two models with irrational expectations and social welfare discussion follow it. Three contributions have been made in this paper: 1) obtain the firm's optimal decisions in rational and irrational market environments; 2) compare results in the rational case and in the irrational case, and further point relationships of these optimal results; 3) prove that social benefits belong to both firm and consumers in the irrational case (this conclusion is different from that in the rational case) and shed light on ways to improve social welfare under consumer irrational expectations.

Does Market Irrationality in the Media Affect Stock Returns?

This paper investigates whether news suggestive of irrationality within financial markets have an impact on stock returns. We construct a lexicon of words for 'market irrationality' and score daily news articles based on the number and proportion of words they contain from the lexicon. We find that reported market irrationality has a significant negative impact on subsequent stock market returns and exacerbates stock market volatility. Furthermore, stocks with large, negative irrationality risk betas outperform stocks with large, positive betas on average by 10.3% annually. Accounting for the Fama-French factors, this results in an alpha of 8.6% annually, which is significant at the 1% level. These results suggest that a large, positive IRR beta amplifies a stock's reaction to market irrationality while a large, negative IRR beta dampens it. The subsequent IRR betas' mean-reversion is consistent with this conjecture.

Contagion in the interbank market: Funding versus regulatory constraints

The contagion potential of mark-to-market accounting rules interacting with regulatory constraints is compared to that of funding constraints in a network of banks. The fair value accounting rules were amended at the height of the crisis to break the vicious link between allegedly irrational market prices and regulatory constraints. Anecdotal evidence from the recent crisis suggests that funding constraints posed more serious problems to banks than regulatory constraints. Simulation results show that, for low equity and high levels of short-term debt relative to liquid asset holdings, the contagion potential arising due to funding constraints is higher than the one due to accounting induced regulatory constraints. Allowing balance sheet valuation to affect the expectations about future insolvency, and implicitly, the roll-over decision of short-term creditors, can mitigate or amplify systemic risk depending on which contagion channel is dominating. These results could be interesting for a regulator wishing to achieve a trade-off between transparency, the main goal of fair value accounting, and financial stability.

Irrational Market Makers

We analyze a model where irrational and rational informed traders exchange a risky asset with irrational market makers. Irrational traders misperceive the mean of prior information (optimistic/pessimistic bias) and the variance of the noise in their private signal (overconfidence/ underconfidence bias). Irrational market makers misperceive both the mean and the variance of the prior information. We show that moderately underconfident traders can outperform rational ones and that irrational market makers can fare better than rational ones. Lastly, we find that extreme level of confidence implies high trading volume.

What Explains Deviations in the Unbiased Expectations Hypothesis? Market Irrationality vs. the Peso Problem

What Explains Deviations in the Unbiased Expectations Hypothesis? Market Irrationality vs. the Peso Problem

What explains deviations in the unbiased expectations hypothesis? Market irrationality vs. the peso problem

Evidence from this study suggests that investor sentiment and the peso problem play a significant role in explaining expectation errors, rejecting the unbiased expectation hypothesis (UEH). The deviation of the UEH for long-term rates is mainly attributable to expectation errors, whereas the deviation of short-term rates is tied to the term premium. We decompose expectation errors and find that irrationality is more apparent in crisis periods, and the rational component becomes an influential factor in tranquil periods.

Contagion in the Interbank Market: Funding versus Regulatory Constraints

The contagion potential of mark-to-market accounting rules interacting with regulatory constraints is compared to that of funding constraints in a network of banks. The fair value accounting rules were amended at the height of the crisis to break the vicious link between allegedly irrational market prices and regulatory constraints. Anecdotal evidence from the recent crisis suggests that funding constraints posed more serious problems to banks than regulatory constraints. Simulation results show that, for high levels of short-term debt relative to liquid asset holdings, the contagion potential arising due to funding constraints is higher than the one due to accounting induced regulatory constraints. Allowing balance sheet valuation to affect the expectations about future insolvency, and implicitly, the roll-over decision of short-term creditors, can mitigate or amplify systemic risk depending on which contagion channel is dominating. These results could be interesting for a regulator wishing to achieve a trade-off between transparency, the main goal of fair value accounting, and financial stability.

Financial market reform: Still too much faith in market rationality

Governments on both sides of the Atlantic have reacted with a raft of new regulations to the US subprime mortgage crisis. The article argues that while these new rules actually touch many of the incentive and information problems which were instrumental in creating the crisis, they only address problems which can be analysed in the traditional neoclassical framework. Issues beyond this paradigm such as underlying market irrationality, bubbles, macroeconomic imbalances or the excessive complexity of the financial system have been left unattended. As these issues played an important role in the genesis of the crisis, new regulations will not suffice to stabilise the global financial system for long.

The Indicators of Stock Market Macro Turning Points During Global Financial Crisis - Application to Dynamic Asset Allocation Investment Strategy Using Index and Exchange Traded Funds

The formulation of a winning investment strategy for the 2007-2009 Global Financial Crisis (GFC), also known as the 'Great Recession', essentially required making one key judgement that the global banking system would survive the Lehman Brothers collapse and identifying the two macro turning points: 2007 top and 2009 bottom of the market. Back in late 2008, investors should have concluded that the massive Central Bank liquidity injection supported by the global fiscal stimulus had the capacity to save the global banking system after the September 2008 Lehman Brothers Bank collapse. There was a good chance the GFC would not turn into a 1930s style Great Depression contrary to a popular bearish conviction.Investment strategists need non-subjective indicators to help them make rational decisions in times of irrational and emotional market behavior. The Author has developed a proprietary Corporate Profits Growth Leading Indicator (CPGLI) for this purpose (not fully disclosed here), supplemented by the analysis of coincident indicators of the macro-turning points discussed in this paper.The analysis identified the following macro indicators of the 2007 market top: subprime write-downs, M&A at high prices, overleveraged shadow banking system, Central Bank’s interest rate cuts, massive Fed liquidity injection and market disconnecting from corporate profits trend.The 2009 market bottom was signaled by the following indicators: extremely bearish investors, very low valuations, dominating 'risk-off' trade, interest rates near zero, falling liquidity injection, expansion of Fed’s balance sheet, corporate profits turnaround, falling initial unemployment claims and rising ISM Manufacturing Index.The paper provides evidence of validity of the active investment methodology. It describes the Author’s actual independently audited CPGLI Dynamic Asset Allocation Investment Strategy based on the coincident indicators discussed here and the CPGLI that after extensive testing has proved to work in 'normal' markets as well as the most unusual conditions of the start and end of the GFC. The CPGLI signals not just the direction of corporate profits growth but also the strength of growth which determines conviction and thus whether to use gearing as well. The strategy returned 83% for the 5 year period from 2006 to 2010 (or 12.9% compounded per annum) whilst S&P 500 recorded a negative return during the equivalent period. Exchange Traded Funds were the ideal, most convenient, and cost effective investment products for the execution of this actively managed CPGLI Dynamic Asset Allocation investment portfolio strategy.

Housing, Wealth Composition and Expected Stock Return

This paper considers a consumption-based asset pricing model where housing is explicitly modeled both as an asset and consumption good. As consumption good, housing introduces housing expenditure share as a novel risk factor. As an asset, it is the major component of wealth with financial asset. The fluctuation of aggregate housing-financial wealth ratio, as a consequence of irrational housing market, impacts the budget constraints of households. It increases household's exposure to risk and shifts the conditional distribution of consumption growth. Using aggregate data for the United States, we find that the fluctuation of housing-financial wealth ratio is a strong predictor for expected stock return. Conditional on this factor, the covariances of returns with aggregate risk factors explain high ratio of the cross-sectional variation in annual size and book-to-market portfolio returns. The micro mechanism of this asset pricing model is also supported by the micro data from subprime crisis.

The (unfortunate) complexity of the economy

The current financial crisis puts the science of economics under huge pressure. Classical economics, which was formalized in the 1950s and the 1960s, is the theory that still shapes much of economic thinking today. Its foundations are the assumptions of economic equilibrium and rational expectations. In theory, deregulated markets should be efficient: prices faithfully reflect the underlying fundamental values, while markets ensure optimal allocation of resources. Any mispricing or forecasting error should be quickly corrected by economic agents, who act with perfect rationality and absolute knowledge about all future states of the world and their probabilities. These equilibrated markets should therefore be stable: crises can only be triggered by exogenous events – such as natural catastrophes, terrorist attacks or political disruptions – and never by the dynamics of the market itself, such as speculation or complex financial engineering. This, however, stands in contrast to most financial crashes, including the latest one, which all seem to be caused by irrational market bubbles.

The railway mania of 1845‐1847: Market irrationality or collusive swindle based on accounting distortions?

The wild boom and slump of 1845‐1847 was the most important of the nineteenth century railway manias, in terms both of its scale and effects on the economy as a whole. It has almost invariably been seen as a market irrationality, a view fundamentally challenged by Bryer’s theorisation of it as a deliberate and collusive device of the “London wealthy”, aided by central government, to swindle provincial middle class investors. This analysis also greatly extended previous perspectives on the rôle of accounting by asserting that accounting practices were crucial to the success of the process and were thus “deeply implicated” in a great, class‐based swindle. The acceptance of such a perspective would have important implications for the way we understand the functioning of accounting and capitalism in the mid‐nineteenth century, but this paper instead argues that such notions are misconceived, looking to both the evidence that was available when Bryer’s paper was written and to recently collected data on the depreciation accounting practices of the time.

The Performance of Stock-Price Driven Acquisitions

Existing literature has shown that periods of high merger activity are correlated with high market valuations. Significantly more acquisitions occur when stock markets are booming than when markets are depressed. Using methodologies robust to recent criticism we show that viewed through an ex-post-performance lens, acquirers buying during periods of low stock-market-valuation appear to be making better acquisitions than those buying during high stock-market-valuation periods. We find that the market welcomes acquisition announcements during high market-valuation periods but is at best indifferent to acquisition announcements during low market-valuation periods. In the long run however, fortunes are reversed. Acquisitions initiated during high market-valuation periods earn negative abnormal returns while acquisitions initiated during low market-valuation periods earn positive abnormal returns. We suggest that acquirers make worse decisions during periods of high market-valuation possibly due to a combination of managerial hubris and market irrationality and that the market learns about the true quality of the acquisition decisions gradually.

Does Investor Misvaluation Drive the Takeover Market?

This paper tests the hypothesis that irrational market misvaluation affects firms' takeover behavior. We employ two contemporaneous proxies for market misvaluation, pre-takeover book/price ratios and pre-takeover ratios of residual income model value to price. Misvaluation of bidders and targets influences the means of payment chosen, the mode of acquisition, the premia paid, target hostility to the offer, the likelihood of offer success, and bidder and target announcement period stock returns. The evidence is broadly supportive of the misvaluation hypothesis.

Internet Stocks: Value-Drivers, Market Irrationality, and Mispricing an Overview of the Emerging Empirical Research Evidence

This monograph provides an overview of the emerging empirical research evidence on Internet stocks. It is primarily intended to serve an informational and educational purpose - as a primer for researchers, investment analysts and managers, financial and technology sector executives, investors, writers, educators, students, policy-makers, etc. It also includes an extensive bibliography of papers, articles, books, and other documents that provide additional details on the issues covered. The monograph covers the following: An overview of perspectives on the valuation of Internet stocks, with particular reference to two valuation approaches that attempt to incorporate the unique characteristics of the Internet industry: (i) adapted discounted cash flow (DCF) models and (ii) real options models. The empirical research evidence on the value-relevance, for Internet stocks, of nonfinancial variables (measures of website traffic and related factors such as strategic alliances, firm visibility, etc.) relative to financial variables (such as earnings, book value of equity, revenues, advertising and marketing expenses, product development expenses, etc.). This includes evidence on the differences in investor perceptions of the relative value-relevance of these factors during the bubble and post-bubble periods. The evidence from empirical studies on market irrationality and the mispricing of Internet and other high technology stocks: (i) the underpricing and performance of Internet IPOs; (ii) over-reaction and irrationality of analysts and investors in the pricing of securities; and (iii) the market valuations of equity carve-outs in relation to those of their parent companies. Some directions for future research on Internet stocks are also provided.

On the rationality of the post-announcement drift

This paper demonstrates that a post-announcement earnings drift, which is often advanced as an example of market irrationality, can arise even if traders act rationally on their information. Specifically, we show that in the presence of share supply variations which are unrelated to information, there is a positive correlation between the unexpected component of current public signals and future price changes. Such a correlation arises from the fact that while prices reveal private information that cannot be found in public signals, non-information based trading distorts the information content of prices relative to the implications of both private and public information. Under these circumstances, markets may appear semi-strong inefficient and slow to respond to earnings announcements even though information is processed in a timely and efficient manner. Our findings correspond well with previously documented empirical evidence and suggest that the robustness of earnings-based "anomalies" may be rational outcomes of varying uncertain share supply.

Excess Volatility and UK Investment Trusts

The possible tendency of stock prices to fluctuate excessively has figured prominently in the debate on market efficiency. Recent research in the USA indicates that the volatility in closed end fund returns is far greater than that of the fund's underlying portfolio. UK investment trusts are the equivalents of closed end funds in the US, however there are a number of institutional differences between them. The purpose of this study is to extend this research by investigating for the UK market the issues examined by Pontiff (1997). Given the sample of trusts studied, it was also possible to develop the analysis in more detail. Our main findings can be summarised as follows: (1) there is evidence of excess return volatility in UK investment trusts similar to that observed in US closed end funds; (2) the excess volatility in fund returns is consistent across different fund classifications and characteristics; (3) Pontiff's (1997) observation that closed end fund returns underreact to returns on the underlying portfolio cannot be supported in our study. The findings provide evidence suggestive of irrational market behaviour. New findings not previously documented for the US market include evidence that the excess volatility is consistent substantially across different asset categories, especially foreign asset categories. Investor sentiment is frequently cited as an explanation for the anomalous behaviour of US closed end funds, since a high proportion of closed end stocks are held by private investors. As similar behaviour is observed in the UK investment trusts, despite a high proportion of institutional clientele, the role of investor sentiment can be questioned.

International Coordination of Macroeconomic Policies: Still Alive in the New Millennium?

In this paper we provide two building blocks for an analysis of international policy coordination: (1) a survey of models of policy coordination, and (2) an account of experience with policy coordination among the G-7 countries and within Europe since the breakdown of the Bretton Woods System. Using these building blocks, we investigate the correspondence between the models and experience and attempt to draw lessons for both the modelers and the practitioners. We find that the correspondence is close enough that the models help in analyzing several instances of actual policy coordination, but that the correspondence could be even closer. As for lessons for modelers, we suggest that they devote more attention to the analysis of information exchange, a key feature of practical policy coordination; to the coordination of different types of policies; to the ramifications of political divisions within countries; and to the implications of market irrationality and speculative bubbles. As for lessons for policy makers, we suggest that they give more consideration to the choice of their ultimate objectives, in particular to whether the current account should always be close to balance; to achieving better internal policies; and to the greater use of fiscal policy as a stabilization tool.

International Coordination of Macroeconomic Policies: Still Alive in the New Millennium?

In this paper we provide two building blocks for an analysis of international policy coordination: (1) a survey of models of policy coordination, and (2) an account of experience with policy coordination among the G-7 countries and within Europe since the breakdown of the Bretton Woods System. Using these building blocks, we investigate the correspondence between the models and experience and attempt to draw lessons for both the modelers and the practitioners. We find that the correspondence is close enough that the models help in analyzing several instances of actual policy coordination, but that the correspondence could be even closer. As for lessons for modelers, we suggest that they devote more attention to the analysis of information exchange, a key feature of practical policy coordination; to the coordination of different types of policies; to the ramifications of political divisions within countries; and to the implications of market irrationality and speculative bubbles. As for lessons for policy makers, we suggest that they give more consideration to the choice of their ultimate objectives, in particular to whether the current account should always be close to balance; to achieving better internal policies; and to the greater use of fiscal policy as a stabilization tool.