ONE of the benefits of my job is the opportunity to meet various types of people - from visionary entrepreneurs, to astute investors and super-smart academics.
This week, while rummaging through stacks of notebooks in search of an interview I did earlier this year, I came across notes made some two years back on a talk by, and my interview with, Vernon L Smith - Nobel Prize winner and the 'father of experimental economics'.
His findings and conclusions about market participants' behaviour in the stock market bears repeating. That's because at different times of our lives, at different cycles in the stock market, we gain new insights from reading such timeless wisdom.
Prof Smith, who teaches economics and law at George Mason University in the US, was awarded a Nobel Prize in economics in 2002 'for having established laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms'.
Before that, economics was widely regarded as a non-experimental science. As Paul Samuelson, author of the classic textbook Economics, wrote: 'Because of the complexity of human and social behaviour, we cannot hope to attain the precision of the physical sciences. We cannot perform the controlled experiments of chemists or biologist. Like the astronomer, we must be content largely to observe.'
Market sense: Uptrend is justifiable as long as macro-economic outlook remains good, corporate earnings grow and market valuation is reasonable
Prof Smith changed all that. He conducted experiments in the controlled environment of the laboratory to test economic theories, in particular why markets work the way they do. He shared that year's Economics Prize with Daniel Kahneman, a professor of psychology and public affairs at Princeton University, whose separate research into human decision-making helped develop the field of behavioural finance.
For his research, Prof Smith got real people to participate in a market created in the lab. The market has specific rules and the participants are cash motivated.
Prof Smith found a big difference between the asset market and the market for goods that can be consumed. In the latter, the market price was formed very quickly because people can experience the consumption benefit of the goods.
But not so the asset market. The thing about asset or stock markets is that people are trading items that do not have a consumer value. The value of an asset is determined by events that are going to occur in the future, and there's a great deal of uncertainty about that, he said.
The value is also determined very much by what other people think it is going to be worth, and how they are going to behave.
In his first experiment, Prof Smith created a market for a stock which would yield dividends in the next 15 periods. In each of the period, the stock might pay a dividend of zero, eight, 28 or 60 cents, with equal probability. The participants, namely his students, were told that the expected dividend payout is 24 cents per period and that fundamental or intrinsic value of the stock at the beginning would be $3.60 (24 cents times 15 periods). The intrinsic value would decline after each period of dividend payment.
The original plan was to see if he and his co-researchers could create trading away from the fundamental value, that is create a bubble in the market by manipulating the information given.
As it turned out, they didn't have to do that. Even in the very simplest 'transparent' baseline scenario, there was a big bubble and a huge crash.
The participants initially started trading at below the fair value. Then, the prices rose to way above the fair value. Prices then traded to fair value towards the end of the trading period, that is, in the 14th or 15th period.
The same experiment was repeated on the same group of students. The second time round, the group already had a taste of how the rest behaved. This time, the bubble formed faster, and the crash came sooner too, with prices falling below the fundamental value. Only in the last three periods did prices trade at the fair value.
The same group of participants was brought in for a third time to trade in the same market. This time, the shares changed hands near the fundamental value throughout.
Prof Smith also noted that in the initial periods of the first session, huge turnover was recorded. The entire stocks were turned over, sometimes 1.5 times. By the third session, there was very little volume.
The lesson here? Giving everyone common information is not sufficient to give them common expectation. 'Everybody still faces the uncertainty as to how other people are going to utilise that information, and what their behaviour is going to be,' explained Prof Smith.
And how accurately one predicts the behaviour of others is a function of experience. 'Information is systematically distributed. But knowledge is not. It is private, it is your own memory.'
The participants in the experiment reached a stage where they rationally priced the stock in their third session. 'They don't get there by applying reason, through common information. They get there by experience. So the convergence to rational expectation is an experiential phenomenon.'
Prof Smith repeated his experiments with different groups, sometimes varying certain conditions.
He found that all the groups took the same number of times to get it right - by the third time, not any sooner.
In his lab, the environment is constant. Out there, the environment changes.
And since learning is context-based, if somehow the context or the environment is different, people may not necessarily translate well what they have learnt previously to the current situation.
Also, in one experiment, Prof Smith gave participants more money, and a bigger bubble was created.
From his experiments, we can surmise that:
liquidity, or huge amounts of money sloshing around in the system, has a tendency to drive up asset prices and is one of the pre-conditions for a bubble.
when market participants are more or less in agreement on asset prices, trading volume and volatility tend to be low. But when there is uncertainty about how much something is worth, be it due to a mixed macro outlook or company-specific factors, there is likely to be huge trading volume and high volatility.
markets learn from previous happenings; if a previous crash is still fresh in people's minds, the probability of another bubble occurring soon after is smaller.
So based on Prof Smith's findings, can we ascertain if there is a bubble building in the Singapore stock and property markets?
Yes, there is a huge amount of liquidity in Singapore currently. In December 2006, and the first two months of this year, M2 - a measurement of money supply which includes currency in active circulation and demand deposits - jumped 19 per cent year-on-year.
This is the biggest sustained increase in M2 money supply since November 1998.
Meanwhile, the volatility we are seeing in the market today is low by historical standards - the sell-off in May last year and in February this year not withstanding.
Does it mean that the market has converged to 'rational expectation', that prices are still rationally priced despite the huge amount of liquidity?
Perhaps to answer that question, we have to first pose another question: Are there a lot of people with third-time experience trading in the market today?
Well, the last three crashes were the dotcom implosion in the early 2000s, the Asian financial crisis in the second half of the 1990s and the severe recession in the first half of the 1980s. In all three occasions, the market had bounced up higher. Perhaps from the three episodes, many have learnt the rewards of bottom-fishing.
This would explain why the corrections we've had so far in the last four or five years are just small ones - not long after the selling began, buyers would come in to bottom-fish, and the market would resume its uptrend.
The uptrend is justifiable as long as the macro-economic outlook remains good, corporate earnings continue to grow at a healthy rate and market valuation is maintained at a reasonable level.
But we will have stay vigilant that all three of these conditions remain valid. Because the longer the uptrend holds, the more complacent the market becomes. The reason is, as Prof Smith noted, price history exerts a huge influence on which information we select to focus on and which to ignore.
So the longer the last crash has passed, the bigger the bubble that the market is likely to create, and the bigger the next crash will be.
Which is why the intermittent corrections we've had are healthy for the market. And also admittedly, the dotcom crash is still not that far back in many's memory. As Prof Smith noted, the market is not efficient, but it is learning all the time.
With knowledge being gained from previous experiences, enormous new discoveries being made on how the human brain works, and with all this information being readily available and easily transmitted in this information age, there are reasons to believe that learning will take place faster today than before. And that the market as a whole is generally more knowledgeable today than before.
Furthermore, the widespread use of futures contracts is a good thing. Prof Smith's experiments found that the inclusion of a futures market helps moderate the bubble in the spot market as the futures contract gives everyone in the market a reading on everyone's expectation in the future. And that helps to reduce the size of the bubble.
If that's the case, then perhaps there are grounds for us to still remain sanguine about the resilience of the market.
The writer is a CFA charterholder. She can be reached at hooiling@sph.com.sg
