Some bubbles and crashes are obvious. For example, no one financially active in Mexico in the 1980s can forget Mexico’s Crash of 1987, which was the biggest in the world at a moment when the whole world was crashing. Timothy Heyman’s 1986 book distilled various valuable works on bubbles and crashes to give his readers the stylized facts they needed to recognize 1987’s bubble as it built up to that famous crash. 1987’s bubble and crash cycle was obvious as prices first rose at a fever pitch, then even more suddenly dropped like a stone. Heyman’s readers and clients took substantial profits out of the bubble, then safely left the market before the crash ultimately arrived.

Other bubbles and crashes are harder to spot. When market prices remain rock steady as underlying fundamentals move, market observers can easily ignore an increasingly serious misalignment. Many analysts argue that the peso band created just such a subtle bubble in 1994. Other analysts, myself included, argue that an interest rate increase anytime between August 1994 and December 20, 1994, could have persuaded foreign and domestic investors to keep Mexico growing on a hard money, low inflation path similar to Singapore, which accomodated the capital that foreigners pumped into its rapidly growing economy by maintaining a large commercial deficit over many years. So, 3.5 pesos/dollar was reasonable to some, but not to others. Varying estimates of fundamentals make such bubbles hard to spot -- although the peso crash that followed the Zedillo administration’s decision to devalue was certainly, and painfully, obvious.

The idea of a bubble with constant prices may seem unusual, but such bubbles are not uncommon in experimental asset markets where laboratory controls allow powerful insights into the market dynamics of interacting prices and fundamentals. They also occur regularly in the field: the slow drop in Mexican closed-end country fund prices was actually a price bubble relative to the rapid drop in their net asset values. With their great variety of forms, bubbles and crashes resist easy definitions. Nonetheless, any useful definition of a bubble and crash cycle must involve an opening gap between market prices and fundamentals for the bubble phase, followed by a suddenly closing gap for the crash -- possibly with overshooting below the fundamentals.

Thinking of market prices in terms of internal dynamics and external dynamics is very helpful. External dynamics are the fundamentals -- cash flow and discount rate news, on-the-ground facts about the asset’s relative value that should lead traders to the correct fundamental price. Internal dynamics are the games that traders play with each other inside the markets -- the bluffs, the emotions, the manipulations, the self-fulfilling prophecies that lead market prices to depart significantly, and sometimes very suddenly, from the correct fundamental price. Bubbles and crashes stem from internal dynamics; external dynamics correct their effects on market prices, bringing prices back into line with fundamentals.

Traders generate internal dynamics via methods such as technical analysis and tracking cash flows into and out of mutual funds, as well as listening for a quaver in the voice of a trading counterpart. External dynamics enter the markets via methods such as fundamental analysis and portfolio analysis. Internal dynamics usually move prices rapidly out of line with fundamentals, external dynamics usually bring prices slowly back into line with fundamentals. Events can violate these generalities, though. Fundamental analyses that expose fraudulent financial statements, for example, have triggered very sudden and powerful external dynamics, while internal dynamics can freeze prices even while fundamentals move strongly.

As a corollary to the new market design work, then, this bubble and crash research endeavors to identify, around the world and in real time, the obvious bubbles and crashes caused by internal dynamics. With literally millions of marketable securities around the world, existing market designs ensure that a researcher can always find bubbles and crashes ocurring in at least a few. To demonstrate that the subject price movements really do come from internal rather than external dynamics, a researcher must accurately predict these significant short-term price movements. Today’s column is just a starter for a series in which I will outline this corollary research.

Readers with questions or comments for Dr. White can call 011(525)595-6045, fax 011(525)683-5874, or email white@profmexis.sar.net

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