Professor Vernon Smith, the joint-recipient of the 2002 Nobel Prize in Economics, is a pioneer of experimental economics and has conducted numerous controlled experiments to explore the dynamics of asset markets. In a ground-breaking paper co-authored by Smith and published in 1988, the authors construct an experimental asset market in which the participants trade a fictional asset with a finite life of 15 periods. Each subject is endowed with cash and shares of the asset, and is free to post bid and ask prices to buy and sell shares at will.
Each share of the fictional asset pays a random dividend at the end of each trading period and the asset’s terminal value following the last dividend payment is zero. The subjects are instructed that there are four equally probable dividend outcomes at the end of each period and are given the payouts – (0, 8, 28 and 60 cents) that correspond to each outcome. Determining the security’s fundamental value is a relatively simple task given the information provided. The expected dividend payout in each period is 24 cents and the security’s fundamental value at the start of the 15-period trading experiment is therefore $3.60 – (15 x $0.24) and declines by 24 cents each period.
Since traders in the experimental asset market have all the information necessary to calculate the asset’s intrinsic value, commonsense would suggest that formation of a bubble is virtually impossible, yet this is exactly what happens. The inexperienced traders initially price the asset at a discount of as much as 80 per cent to its fundamental value, though the asset becomes overpriced by the fifth period and a massive bubble is created by the tenth period with the asset often reaching three to four times its fundamental value and sometimes, the price even exceeds the maximum possible value the asset could return in dividends – the case where the highest dividend of 60 cents is paid at the end of each trading period.
Needless to say, the asset’s price collapses towards zero as the experiment enters its final stages. The substantial deviation of transaction prices from fundamental value alongside the large turnover of shares, which often amounts to as much as six times the outstanding stock of shares over the 15-period experiment, runs contrary to the predictions of economic theory. The surprising result is often explained by the speculative motive whereby rational traders judge the behaviour of other participants to be irrational, and knowingly purchase overpriced assets with the hope of offloading them to irrational subjects at a higher price – the so-called ‘Greater Fools.’
Thus, the presence of irrational traders is not necessary to produce a bubble so long as some traders believe others’ behaviour to be irrational. However, this conclusion is undermined by recent work conducted by Vivian Lee and others, which controls for the speculative motive and limit the role of each subject “to that of either buyer or seller, completely eliminating the ability of any agent to buy for the purpose of resale.” Prices still deviate substantially from fundamental value on heavy trading volume, and the pattern of prices exhibit the same boom-and-bust features originally reported by Smith. It seems inexperienced traders behave irrationally after all.
Professor Smith reveals that the only way to reliably eliminate price bubbles in experimental asset markets is through increased experience in the same environment. Smith invites the original subjects to return for a second experiment with the same parameters as before, and contrary to what might be expected, a further bubble develops, though its duration and magnitude are less than observed in the first experiment. The bubble gathers momentum far more quickly than in the first experiment with prices typically moving above fundamental value in the second period and reaches its climax by the seventh period with the security peaking at roughly twice its fundamental value. Importantly however, upon returning for a third experiment, “trading departs little from fundamental value.”
The evidence from experimental markets would appear to suggest that a third bubble is virtually impossible to produce, but in a 2008 paper entitled, “Thar she Blows׃ Can Bubbles Be Rekindled With Experienced Subjects?”, which Smith co-authored with Reshmaan Hussam and David Porter, the authors demonstrate that it is possible to precipitate a further bubble under certain circumstances.
The experiment is constructed in a similar manner to the previous two, but for an increase in both the variability of dividend payoffs and initial cash levels. There are now five equally probable dividend outcomes at the end of each period – (0, 1, 8, 28 and 98 cents); the amount of stock distributed to subjects is halved and their initial cash level is doubled. The greater liquidity combined with the increased variability of payoffs results in a third bubble that peaks in the fourth period, earlier than the first two experiments, and at a 75 per cent premium to intrinsic value.
The conditions in today’s market environment would appear to resemble Smith’s third experimental market as the variability of outcomes following the “Great Recession” remains wide, while near zero interest rates combined with quantitative easing has allowed stock prices to trade at above-average valuations once again.
The evidence from experimental asset markets suggests the Federal Reserve has given birth to another bubble in stock prices. Investors should partake in the central bank's deliberate attempt to push asset prices higher and stay long the stock market for now.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.