Dot com and a housing bubble

Executive Summary

        This research paper will attempt to answer a two-part question Why was there a 'dot com or housing bubble'? Is the market not efficient enough to 'see through it'? First, we will look at the dot com bubble from entrepreneurs' and investors' perspectives as to why it occurred. Then, we will examine the housing bubble from the perspectives of banks and investors. Based on our findings and inferences from both the dot com and housing bubble, we determined that the market was not efficient or inefficient. Market inefficiencies due to irrational human behaviour, information asymmetry, and lemming factors will be mentioned in details.

        During the course of our research, two interviews were conducted in total, one for each of the dot com and housing bubble to help us answer the questions. We asked the interviewees the same questions that we're trying to answer in this paper. One of the interviewees we interviewed is working in the financial industry with exposure to financial derivatives and financial risks. He commented that housing bubble happened because investors were over-confident; they had a general perception that real estate investment was a safe one and had many irrational expectations. Information asymmetry throughout the lending systems and low interest rates were other factors that contributed to the increase in housing prices. In the short run, the market is not efficient because the transactions for housing is unique which makes reporting housing statistics even harder, and these extra barriers allow market participants to manipulate housing prices; however, market is self-correcting in the long run.

        For the other interview, we interviewed a junior accountant who is a Certified Public Accountant (CPA). He explained to us what he witnessed during the dotcom bubble regarding both investors and businesses. He was able to give us insightful information regarding how he witnessed the stock market's operation to be during that time period when internet stock prices were on a rise. He stressed more one the irrationality of investors and entrepreneurs leading to the main cause of this bubble. Much of what was gathered was similar to the theory surrounding the housing bubble.

Most of the information gathered thorough these interviews and from outside research will be used throughout our research paper in the attempt to answer our research question regarding the market efficiency in see through the housing bubble and the dotcom bubble.

Introduction

In accounting we are thought that the market is efficient, in that, the market at all times reflect all publicly known information and everyone has access to all information at the same time. Simply, there is no information asymmetry. Controversial to this notion of the efficient market theory we have notice through the past decade or so, the effect of economic bubbles in the stock market which has led to the questioning of the efficiency of the market. As such, in this research paper, our research question that we will attempt to answer is of two parts; "Why were there a dotcom and housing bubble and was the market not efficient enough to see through them? This paper contemplates the causes of the dotcom and housing bubbles, evaluating factors such as unrealistic expectations, speculative behavior, irrational thinking, greed and the part financial institutions played to contribute to these bubbles. In this way we are able to take a view at the stock market during these two periods in time, including investor's and entrepreneur's behaviour. We will trace any significant patterns and observations and use what has been gathered from these two incidents as a way of evaluating the efficiency of the market to see through them and to answer our research question.

What is an Economic/Market bubble?

        In this paper, when we speak of 'bubble' we are referring specifically to market, pricing or economic bubble, which are used inter-changeably in financial accounting terms. We define 'market bubble' as being a situation which arises when investors, due to their market behaviour, influence the market price of a share specifically by driving market prices up or down. As such, market prices may keep rising as more and more investors invest in these shares, thereby driving the prices higher and higher creating a bubble like effect. Ultimately, according to our interviewee, the result is a bull market - known throughout the investing world as a prolonged period in which investment prices rise faster than their historical average and can happen as a result of an economic recovery, economic growth, economic boom or investor psychology. On the other hand, a bear market would be the complete opposite scenario with falling prices. What basically happens is when investors see that the stock prices for a particular company are on the rise, they anticipate that the current market behaviour will continue indefinitely. As the bull market suggest, their psychology of the current situation lures them to keep investing and over-valuing the shares.

We will speak of the 'bandwagon' effect we are referring to the situation which results when investors see that share prices are shooting up in value and they want "to get in on the action, as such they jump on the 'bandwagon' or 'follow the crowd.' However, as we will soon see, as more and more people jump on the 'band wagon' it influences the market bubble to keep growing, pushing market prices higher and creating a situation far from the reality. Thus, just like any bubble, as it expands, it will eventually burst and cause an inverse deflationary effect. In this case, when the bubble busted it caused the market prices to incredibly decline in value and those who had largely invested in such market shares suffered from huge losses.

Overview: The Dotcom Bubble

The emergence of the World Wide Web as the resource capital and virtual information super-highway meant that investors had a real time mechanism for monitoring the stock markets and ensuring they made the best possible investment. Not only did the Internet enhance their decision making process but it transformed how business was conducted; suddenly the click of a mouse was enough to seal a deal.

        This led to the emergence of a significant number of companies capitalizing on the Internet era. This era in my opinion is one in which many investors embraced the mentality that technologically related companies would yield the highest return on investments with low associated risks. As this phenomenon grew, many companies were created and investors were enticed with the words "E- or ".com. As a result, these stock prices sky-rocketed and all was well, but soon the reality of the situation would cause a stock market crash and unveil the "dot com bubble that had eluded the naked eye.

        The rise of these stocks and the boom in the internet based companies could only mean the end was near and when the crash happened in year 2000, investors were reminded of the long time actuality that "if it's too good to be true, then it probably is.

As we examine the situation, we can conclude that most, if not all of these dot com companies were not created to earn long term profits and be in existence to promote growth but more for short term gains with no business plan. The hype was pervasive and grasped the attention of everyone: young and old, experienced or inexperienced (in investing) and even the risk adverse, risk seeker and risk neutral. The stock market promoted prolonged investing and aided in the booming prices and while the prices were overvalued, many refused to cash out because of their high rates of return.

However, clearly red flags were being waived and the correlated push for technology, at a time when the world feared the Y2K millennium bug continued to foster the boom. Still, as the red flags were ignored, the first and worst mistake in investing was made: never rely on momentum. Any gambler knows that when the stakes are high and everyone is doing it, you cash out, but many continued riding the bandwagon and the stock market crash / dot com bubble bust was looming1.

        The dot com bubble bust thought us one vital lesson: e-commerce was a great idea to combat retail stores, but its introduction and take off was somewhat premature and has a scar lingering that will prevent any future tries. We learned that at the time of the dot com bubble bust, many investors were individuals and venture capitalists who lacked the knowledge and ignored the signs that would have mitigated the losses. We also learned that the stock market is influenced by many diverse buyers and sellers and there is an inherent risk of susceptibility at any given time1.

Investors' Behavior during the Dotcom Bubble

        We have learnt throughout our many years of studying finance and accounting that the valuation of a company depends on specific criteria. The economic theory of the rational investor thinking teaches us that as investors, we rationally evaluate any business before investing in it. According to Scott, the concept of a rational individual simply means that when investors make decisions regarding investments, they will choose the act that will yield them the highest expected utility or return. They will search for additional information, use historical trends and other useful statistics in helping them to reach a rational decision. Scott also goes on to say that investors are risk averse, which means that investors don't like risk, they will choose an investment with little risk and high returns, that is, there is the trade off between risk and return (William Scott:).

When deciding to invest in a business, as investors, we look at the business's present cash flow, its ability to generate future cash flows and the timing related to the generation of this cash. In addition, we evaluate the risk factors involved that may reduce or increase future cash flows, and we look at what are the risks and rewards requirement for investors. If we perceive a company to have the potential to generate significant future cash flows with little risk, as rational investors we would invest in such a company so as to receive high returns. According to Ronan McGovern, associate director of AIB Corporate Finance in his article entitled "Lessons learned from the dotcom crash; there are two methods for evaluating the value of any business; relative valuation and discounted cash flows analysis. When we speak of relative valuation we mean taking companies of similar business activities and comparing their market value, while discounted cash flow analysis entails looking at the business's intrinsic value based largely on its expected cash flow3. (Ronan McGovern, "Lessons Learn from dotcom crash). As rational investors, cash flow is the most important factor of any business, it says a lot about a firm in the financial market.

        However, taking all the above into consideration, if this was the case and investors are rational as we consider them to inherently be, we must ask ourselves why then was there a bubble created in the dotcom era? The answer here is simply that the economic theory of rational investors is only theoretical, that is, in reality investors are irrational and impulsive. They will go with the flow without thinking about the consequences of their actions and without reverting to the foundations of investing. When we examine the timeline of the dotcom bubble, according to Ronan McGovern, it is evident that these dotcom companies were incurring negative discounted cash flows and incurring losses higher than those companies operating at a profit and with positive cash flows. As such, investors jumped on the "bandwagon and kept investing more and more into these 'highly valued' companies without taking a step back to really evaluate these businesses from a cash flow perspective. It is simple to see that this market behaviour contradicted what economists assumed in their theory of "rational investor behaviour.

What was the Dotcom Bubble

        The dotcom era took place roughly around the period of 1996 through to 2000, during which time everything revolved around the idea of internet technology. This period was marked by the founding of a group of new Internet-based companies commonly referred to as dot-com companies. Companies were seeing their stock prices go through the ceiling simply by adding an "e prefix to their name and/or a ".com' to the end. What was happening was these companies were testing with substitutes for various technologies as well as different business practices for which they were supported through private equity investments. The intention here was to create a business model that would increase growth and company profit. The focus was on technology and the business's key performance was measured by revenue growth rather than earnings and the majority of the players were new and young entrepreneurs in the market. The legal and regulatory environment of the marketplace was also not governed. The model that these entrepreneurs created had numerous built in misconceptions. Primarily, most of these companies viewed competition as though it was a perfect market in which their plan was to monopolize their respective sector through network effects.

        Investors were so enticed with the idea of dotcom technology that many entrepreneurs at the beginning of their quest witnessed their company's stock values sky rocketing as irrational investors continued to invest more capital into their businesses that eventually led to the overvaluation and mispricing of these stocks. A situation was created in which investors were willing to overlook traditional metrics such as price equity ratio in favour of confidence in technological advancement and as such, was easily persuaded to invest because of the dotcom concept. This belief led many investors to influence the stock price, which in turn created the bubble. As investors started to invest more into these companies, prices got higher, thus increasing the value of firms and generating more capital for them, leading to entrepreneurs who got carried away and lost sight of what was really important; increasing the firm's value. Instead, they were less cautious and became greedy, just trying to heap in what they could at that point in time, not thinking of the repercussions of the long term effect this would have on their companies.

In summary to capture the essence of the dotcom bubble, Richard Fletcher stated in his book:

"Supply and demand drove the extraordinary market valuations of the dotcom era. Overwhelming media attention and a constant flow of promotion by newly listed Internet firms created demand for Internet investments. Too much money chased too free sound Internet-based businesses. Many Internet companies rushed to make an initial public offering and entered the market with relatively small floats. Investor demand quickly bid up their immediate post-offering price only to have them fall later to levels below the issue price.

From the diagram in Exhibit 1, we see that the period between mid 1999 to the beginning of 2000, Internet stocks were doing great, they were rising tremendously in value as compared to the NASDAQ and S&P 500. There was a boom in Internet stocks throughout that period, where more and more investors keep pushing money into the stock market bumping up the prices for these internet companies creating what we have referred to as the dotcom bubble. However, starting mid 2000 internet stock prices began to fall, the bubble was bursting and soon the dotcom bubble would collapse causing total chaos and huge loses for both companies and investors.

Economist speak of the theory of the market being efficient, in that, the market automatically adjust to prevent such an event as the dotcom bubble from taking place by at all times reflecting all information publicly known preventing insiders from have information asymmetry as using it to their best advantage. If this theory is right, why then was the market not efficient enough to prevent the creation of the dotcom bubble and even correct it after it was created?

Irrational Behavior and Unrealistic Expectations The Housing Bubble

The concept of an efficient market captures the idea that prices of real estate that make up a particular market, constantly reflect all information pertaining to those homes and therefore, those homes will always be adequately priced. A key fundamental assumption embedded in this concept, is that the participants in the residential real estate market are rational individuals with realistic expectations, which means that, on average, an investor will not pay a certain amount for a particular home if the information available to the public does not support that amount. Do these concepts manifest themselves in reality? The recent significant correction in home prices in the U.S.A. and Spain will certainly call into question any theory that implies efficient real estate markets.

Fama's Efficient Markets Theory assumes that rational market participants use past home prices as the basis to setting a fundamental value to homes, yet when put into practice, it seems that buyers completely ignore past prices and therefore, irrationally drive home prices. According to Brian Peterson, between 1998 and 2006 home prices in the U.S. appreciated 45.26%, of which 23.84% (more than half of the growth) can be attributed to the irrational behavior of buyers and sellers. These figures bring into question the rationality of the participants in the U.S. residential real estate market especially those purchasing at the peak of the cycle - and thereby its efficiency as well.

When home prices increase in a rapid pace, the strength of unrealistic future expectations increases as well; buyers and sellers become overoptimistic and fall into a belief that such growth in prices can be sustained. Buyers developed adaptive expectations, where they base their decisions on narrow short term past information, rather than long-term historical prices. These elements of excessive optimism and unrealistic expectations contributed to a further increase in demand for homes, which in turn further increased home prices.

In pursuit of quick profits, many buyers intensified demand and thereby further increased home prices to unreasonable levels with speculative behaviour. This created a culture of speculation where it became acceptable to hold unrealistic expectations of future home prices and fuelled a cycle of short holding periods. Buyers and sellers began to hold homes for shorter periods of time with one objective in mind to turn a quick profit. This short-term holding phenomena accelerated the growth cycle of home prices beyond fundamental demand and supply. These elements of speculation and condensed holding periods only intensified the already robust demand for homes and contributed to a further escalation in the prices of residential real estate.

Similarly to the U.S., housing bubbles developed across Europe as well. A study conducted on the effects of expectations on home prices in Spain found that home prices deviated by more than 18% from a fundamental valuation and that the increase in home prices pulled on irrelevant variables. These variables speak to unrealistic expectations and irrational behavior buyers and sellers in the residential housing market displayed. Similarly to the U.S., many Spaniards turned to speculation on home prices to turn a quick profit by constantly buying and selling properties - driving both demand and prices. This speculative behavior created a momentum trend, where everyone wants to jump on board and participate and benefit. Younger, first time home buyers jumped into the market further pushing its limits, driving demand and in turn home prices to new heights. 18] These younger buyers were more receptive to risk and highly influenced by short term information due to their young age and inexperience with past housing slumps and therefore, intensified demand to higher levels, ultimately driving home prices upwards.

The Essential Element of Risk

The concept of efficient markets assumes that with greater potential for reward (profits), the greater the amount of risk associated with a particular investment. A logical concept, yet it seems that the element of risk did not exist when some American home buyers purchased their homes in hopes of turning a quick profit.

When a home buyer purchases a home, he or she usually deposits a down payment which is often a significant amount this amount represents the risk that the buyer is taking with the specific investment. With flexible and irresponsible lending practices such as zero percent down, greedy speculators motivated by quick profits had an essential element to an efficient market (associated risk) taken out of the equation, leaving only potential profits. When these individuals purchased homes for short holding periods in hopes to turn quick profits, even with the notion that home prices might depreciate in value in mind, the fact that none of their money was at risk made them take significant risks and purchase overpriced homes at the peak of the market.

The scenario described above is also true to any point in the housing cycle and is not exclusive to the peak of the housing bubble. Zero percent down loans fuelled a flow of irresponsible greedy individuals hoping to turn quick profits, some purchasing a few homes at a time for short holding periods. This phenomenon contributed to a further increase in demand and thereby further increased home prices to unreasonable and non-sustainable levels.

The Housing Bubble and Lending Practices

To understand the creation of the housing bubble, one has to look at the lending environment during the period of 2003 2006. To take advantage of the booming demand for housing, banks began to originate mortgages to borrowers who have low credit profiles. This group of borrowers is typically called subprime borrowers. "Subprime borrowers typically have weakened credit histories that include payment delinquencies, and possibly more severe problems such as charge-offs, judgments, and bankruptcies. Essentially, lenders are taking on more credit risk lending to subprime borrowers. The mortgages underwriting standards during that period of time was more lenient or almost non-existent. In order to make profit out of transaction fees and higher interest rate margins from subprime lending, most of the mortgages applications were being approved by the bank without properly assessing the creditworthy and the repaying capability of the applicants. This inappropriate incentive has led to unqualified mortgages being approved. To generate higher volume, some banks even facilitated application process through automated mortgages approval system to shorten the approval process. These lenient standards and the reduced processing time increased the demand for housing and mortgages where everyone was able to obtain a housing loan. "In 2005, 1,283,000 new single-family houses were sold, compared with an average of 609,000 per year during 19901995 in the United State

The predatory or opportunistic behaviors of banks are being blamed as one of the reasons for housing bubble to exist. Banks loosened their loan standards to fulfill the excess demand for mortgages. In retrospect, housing bubble would not have happened if banks had taken a stricter lending policy, which serves as a firewall to unqualified applicants. Borrowers without outstanding credit should not be granted loans and with this control in place, the impact of the housing bubble will be minimized and eventually eliminated. But in reality, the incentive nature of the business would not allow any profit making opportunities to be passed on. To make profit, credit risk can be compromised. Consequently, this business model began to brew a perfect storm for a housing bubble.

In addition, banks, which have the first hand information of their applicants, are aware of the inherent risk of this excessive lending. They realize that these subprime mortgages carry higher default risk. Traditionally, a prudent lender would try to minimize bad loans on their balance sheet. The underwriting policy was in place to prevent lending to subprime borrowers. However, bank is willing to act as a middleman, for a portion of the excess interest rate margin, as long as they are able to sell these subprime loans to third parties. Through securitization, lenders move these risky loan assets off their balance sheet to the secondary market. Banks therefore have limited risk exposure by acting only as intermediates between home buyers and secondary market where fund obtained from investors are quickly turned to borrowers. They can reap in profit by repeating the process as quickly as possible, as long as the housing demands and prices continue to rise. "Mortgage standards became lax because each link in the mortgage chain collected profits while believing it was passing on riskto the next link in the chain...... All of these businesses accepted profits and tried to leave the next guy vulnerable to risk. That's an example of moral hazard Investors in the secondary markets who have limited information invest in the bonds based solely on the information obtained from rating agencies. Rating agencies are compensated by the banks or assets managers in the secondary market to evaluate the riskiness of their investment products and often, favorable ratings are given to the public to please the managers. The conflict of interest by rating agencies always results in bias and unreliable ratings. These often highly rated securitized products would then sell like hot cakes as these secondary investors believe that the housing market will continue to rise and the return on these mortgage bonds are attractive. Unfortunately, under information asymmetry, the imperfect information flow between borrowers (home buyers), lenders (banks) and investors of the secondary market allow for more mortgages to be repeatedly underwritten, repackaged and sold, enlarging the bubble. The booming market along with positive ratings on bonds and securities tend to increase investors' confidence and persuade them to invest more, in hoping to generate higher return given the growing market. They were unaware of the consequences when housing prices fell. Borrowers will start defaulting on their mortgages, being unable to resell their homes. This will further push the prices down, creating a downward spiral. But in the mean time, speculative investors continue to believe the upward housing trend, overlooking or ignoring the negative consequences and making their investment decisions basing on market trend. As long as capital were continue to be raised in the capital market from investors and make available to house buyers, the borrowing-lending cycle is self-fulfilling. While this could be the perfect resolution under efficient market, the demand-supply cycle in this case does nothing but further overwhelms the over-reacted market flooded with investors with irrational expectations and fuel the growth of the bubble.

In light of the lax and predatory lending policy, lenders created various mortgage products to attract higher mortgage volume. Bank introduced the Adjusted Rate Mortgage (ARM) to attract more potentials home buyers. To make borrowing more affordable, banks offered teaser rates, which were usually lower than the average market rate for the initial terms of mortgages payment, but will be adjusted back to their market rates after a certain period. Investors tend to find ARM attractive and worthy, thinking that they could take advantage of the lower borrowing rate to acquire properties and resell them when the value increases. "The initial interest rate for an ARM is lower than that of a fixed rate mortgage....... A lower rate means lower payments, which might help you qualify for a larger loan. Many homebuyers were not concerned with the liabilities they were bearing because they believed that they could easily refinance their mortgages even when higher rates kicked in, as long as the housing prices continued to escalate. On the other hand, banks were not concerned with their capabilities to offer loans as investors in the secondary market acted as providers of these excess capital resources. Homebuyers who were optimistic about the housing market acquired numerous properties as a form of leveraged investment, hoping to flip them for a profit. Consequently, one can blame ARM for driving the housing prices further up as it fueled the mortgage volume during the bubble.

At the end of 2006, home prices started to fall in various parts of United States. Demand began to cool as prices escalated to an unjustifiable level. Speculative homebuyers started to default on their multiple mortgages after failing to resell their properties. Refinancing was not possible when house prices were below the outstanding loan balance. The prices dropped further when foreclosed houses were brought back to the oversupplied market when the owners defaulted on their mortgages. All participants in the housing business were severely affected. Home owners were trapped with negative equity and the mortgage bond investors suffered a huge loss as defaults continue to happen. The in-progress constructions are forced to discontinue as homebuilders started to default on construction loans as the demand for housing evaporates. Panics set in and market participants revised their previous expectations and rushed to get out of the market, which further exacerbated the drop in housing market. "Sales of new homes dropped by 26.4 percent last year to 774,000. That marked the biggest decline on record, surpassing the old mark of a 23.1 percent plunge in 1980.

In general, market participants often act based on the herd mentality and incentives. Market participants rushed into the housing market, with the matchmaking of low interest rates, brewing up a perfect storm. Market is not efficient enough in the short-run when all parties act in one direction. The emergence of leveraged speculative investors, subprime borrowers, irresponsible mortgage officers, opaque securitization and asymmetrical information among all market participants led housing prices spiked to an unsustainable level. Eventually, the bubble burst and the market corrected itself, but it came with the price of the worst recession since 1929 with high unemployment, contracted growth.

The Market Is Not Efficient Enough To See Though It?

Efficiency exists in nature, in a Darwinian sense, in that survival is predicated upon a balance of functionality. Balance however requires a measure of both ends of a spectrum. Making up a spectrum of black and white, we will find that balance exists in the middle shades of grey. Reality dictates that balance is not always perfectly located and observable at the centre point, but at a point where the two extremes interact in a survivable way. Our markets operate in this way as well. Market efficiency theory is a finance theory term that indicates that in a perfectly efficient market, all information is known; the share price already reflects this information and therefore any over or under valuation comes as the result of randomness. In the real world, markets do not have the luxury of black or white, which means they cannot be absolutely efficient or wholly inefficient. Instead, just as in nature, it is reasonable to see markets as essentially a mixture of both. In addition the profit margin in any market comes from the ability to exploit the over and under valuation of the tradable commodity. If these over and under valuations were truly random and the ability to predict this valuation as a result was even odds, then there would be no market because in the long run any participant would only break even. This is unsustainable and would give rise to some other format of a market. Since the reality of a market lands on the spectrum of efficiency somewhere between the absolutes of efficient and inefficient, and relocates upon this sliding scale based upon circumstances that impact the aforementioned markets, we can see that we do not have a truly efficient market. Instead in Canada we have a semi-strong one where it is suggested that the participants are fully informed in regards to the public and historical information available for a given commodity. Armed with this knowledge, the question then becomes "within the confines of market efficiency theory and existing in a semi-strong market, could one foresee the collapse of the housing and dot-com bubbles? The answer to this is no. This theory fails to predict this collapse because if it foresaw the losses incurred, then the market prices would have reflected these losses and investors would have been significantly more cautious. Faced with this glaring reality we must examine why the theory failed.

The purpose of any theory is to try and predict and/or quantify the interactions between elements, in this case, humans. From a basic standpoint this attempt is sheer folly on its own. Human beings are governed by a number of non-quantifiable/unpredictable influences and impulses. The theory of market efficiency posits that the price of an item reflects the knowledge about its value but it does not take into account the idea of free will. Humans have the right to pay attention to or completely ignore the known information. They do so for any number of reasons. We are governed by primal needs for food, companionship and shelter. In the housing market there is a strong element of personal freedom attached to the purchase of a house as well as pride and vanity. These elements can explain why someone might buy one despite the price being unaffordable or that the market is indicating that it is not a good time to buy. In addition, people tend to have a group mentality. Like the conception of lemmings running off a cliff as mentioned before, people were all too eager to rush into a tech market that boasted great returns despite the fact that this was ultimately just a boast and lacking in substance. Had the investors made an informed decision based on the available financial information that showed that companies were focusing on growth rather than profits, they might have seen that these start-ups were cannibalizing themselves in the name of expansion to the point of collapse. Irrational human behavior plays a vital role in our decision making. It impacts what we do. For every investor using technical analysis, research and professional knowledge to make a decision, there are any number of random whim based ventures occurring at any time. To many the markets are just another form of gambling. The perception is that it is a way to make a quick and exciting buck. The reality is usually quite different but without these people, there would be insufficient funds and participants in the markets. All of these normal human psychological factors impact this theory but are not taken into account by it whatsoever. Furthermore, there can be even more significant human factors involved that can compromise this theory. People can be rational, but can also be greatly affected emotionally. Any trip to a casino can demonstrate how loss averse a person can be. Holding on to a losing bet in the hopes that it will turn around and recoup its setbacks is one of the most common and human actions we take and yet the discipline required to avoid this is not taken into account on a theoretical level. People also have a pain threshold where once a loss has overwhelmed that threshold, they are immune to understanding how much worse it is getting. Similar to a body going into shock, the attention shifts elsewhere and allows the setback to worsen. This is not consistent with the idea of a price reflecting the known information about the commodity it represents.

Another factor that the theory of market efficiency fails to address is momentum. If the Canadian market is defined as semi-strong in terms of market efficiency then public knowledge and past prices are reflected in the market's prices. Public knowledge is a tricky beast though. We live in a day and age where access to information is overwhelming to the point of excessive. Looking past traditional information sources of print, news outlets and the Internet have revolutionized the ability to follow information. It is nearly impossible to flip channels between news outlets and not see stock quotes flashing across the bottom of the screen and to hear commentators expounding the current uplifting or doom and gloom outlook that is popular at the time. The Internet allows access to resources that were unimagined 25 years ago. With all this information out there it becomes nearly impossible to process it all and highly probably that combined with a desire for profit (read greed) a person will become swept up in the tide of public opinion. Add to this the element of emotion coupled with momentum as mentioned earlier and a volatile market is just around the corner. This momentum will drag in investors who normally would have stayed in the relatively safe shallows. When the dot-com bubble was growing, every news outlet and Internet media outlet was expounding the miraculous growth and impressive strength of the tech world. The future was here and it lived in a microchip. Anyone who wanted to get in on the next big thing needed to invest in tech. Well technology has been rapidly advancing for the last hundred years and continues to advance today, but investors are much more wary now because of the way people jumped on the tech bandwagon and got burned. As mentioned in the interview, investors in the housing market were overconfident in the stability of house prices and ended up being pulled into a situation where they lacked full information. This is very similar to what happened in the tech market and with a similar result. The theory of market efficiency however failed to pick up on this unsustainable momentum and instead forced the lemming-like nature of humans to learn their lessons the hard way.

Human factors and momentum aside, the other primary issue that the theory of market efficiency does not address is that of the quality and manipulation of the information that is relied upon to make decisions. It has already been mentioned that the Internet and media provide massive amounts of insight and data concerning the markets. This data does not come from unbiased sources though. Most news stations and Internet sites are affiliated with some sort of concerned interest. The same people who can manipulate what information is presented to the public are the same ones who are profiting from the transactions of the market. It seems to be an accepted truth that gossip and rumor are the driving forces of many published commentators. The truth though is that biased information can lead to unpredictable results in the markets.

Another manipulation of the information is done through government intervention. The Bank of Canada sets interest rates with the intention of affecting the market. In order to recover from the recession, interest rates were set at incredibly low rates to stimulate spending. This is not a natural occurrence; but instead a direct manipulation of the market in an attempt to effect changes. Normally the market makes its own adjustments on a longer-term basis and with more gradual adjustment. This allows the public to assess the information with less of a lag between cause and effect. When the interest rates were lowered recently this caused a surge in the housing market but also a sharp upswing in people's perception of the recession. With housing markets picking up speed, the idea was floated around that the recession was ending. Despite this message, unemployment continued to lag and the economy remained slow in other sectors. It was essentially a false positive directly attributable to manipulation of available information, this is reiterated in the interview where it is stated that the market is not efficient in the short run and was not self-correcting. The market was not as liquid as stocks and has related statistics that are not representative of what is really happening. In addition one of the reasons for the slowdown in the economy, and thus the markets, was mentioned earlier in that greed from the banks and investors created an untenable housing market. Banks were approving loans for people incapable of paying them off. Once approved, they were selling the debts to a secondary market. The bank's greed for profit helped contribute to the failure of the loan agreements. Speculators who invested in them ended up losing just as much as the homeowners. This is a factor of greed over the common good. Profit is necessary but sustainability of profit is the key.

The third method of manipulation comes from business entities themselves. Companies must produce financial documents according to GAAP but common sense dictates that it is also in their best interest to ensure that the company looks as favorable as possible. Director bonuses and the ability to raise capital can be directly affected so while this does not stop them from doing their best to comply as minimally as possible, it is a fine line between being open and honest, and misrepresenting the facts. They constantly look for ways to positively state their positions while remaining within the established rules (and sometimes straying beyond these protocols as well). Without truly accurate and unbiased financial statements it becomes much more difficult to determine the true position of a company.

All these methods of manipulation end with public information that is neither fully reliable nor relevant however get used anyway. The theory of market efficiency never addresses the fact that the incorrect public and historical data could lead to a price that reflects this data but not reality.

Conclusions

In every market there is an element of risk. Without this risk there would be no desire to compete for profit. The various markets are composed of a multitude of constantly changing factors that make any theory or evaluation of the circumstances difficult if not impossible. The lessons learned from the dot-com and housing bubbles are good examples of that. Within the chaos of the moment there is knowledge to be had. There are trends to be observed and significant principles to find. One of these principles is that while we can guess what many people will do, we cannot predict the actions of all. Humans are at times rational and at other times irrational. They can get swept up in a tide of greed and consumed by the sharks waiting just beyond the shallows. This is exactly what happened with the dot-com and housing market bubbles. That being said, there were some who did predict the outcomes accurately. Not everyone lost out. Instead, banks made a great deal of money during the housing bubble as a result of their loans. Tech corporations took in millions of dollars before ending up bust in the tech bubble. The idea that everyone ended up broke is a fallacy. The trick is to predict what the masses will do and in anticipating that, prepare for it. A theory of market efficiency is therefore incredibly valuable if it could predict these turns of fortune. Unfortunately it cannot. In categorizing markets as efficient or not, it shows its own inefficiency. Ultimately the proof is in the pudding. Had the theory had the ability to predict the collapse of the bubbles, then there would not have been a bubble and even if there had, much fewer would have been a victim to its implosion. At the end of the day, there are a precious few who have sufficient information to make a truly informed decision about any investment and they will always have to compete with those who employ chance or illicit information to reach their ends. That makes any theory based on public information potentially useful, but ultimately only moderately efficient on its own.

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