The check for bubble driven by investors with extrapolative expectations. Adjusted weights of value, growth signals. New model of expectation formation. Empirical analysis. Noise trader risk in financial markets. Contrarian investment and extrapolation.
Introduction Financial bubbles have triggered off the disturbances in the economies across the world. Tulip Mania (1637), South Sea Company (1720), Mississippi Company (1720) are one of the earliest cases when the bubble was detected: in all of them the actual price started to exceed significantly the intrinsic value of the good, whether it is a commodity good or a stock. Under one of the rules of thumb presented in their work, the representativeness heuristic, the results received on the small sample are transmitted to the whole population. This is called “extrapolation” and, when agents follow this bias, they extrapolate past returns on the future ones. Essentially, this is the mechanism of bubble formation in the extrapolators-driven models. In this paper the recent financial bubble on the Chinese stock market will be considered. It took place in the second quartile of 2015, reaching the top in middle of June and then collapsed, leading to dramatic fall of 30 % in one month. The motivation for my work is to check whether the agents with extrapolative expectations about returns were present at the Chinese stock market at the moment of bubble formation and, if they were, at what degree they influenced it. There has not been a lot of work done yet with regards of origins of this bubble; moreover, there were no research conducted to check for extrapolation. Apart from overall check for presence of extrapolators, other related questions will be addressed later in the paper. How did the expectations of agents developed with the development of the bubble? Was there any significant difference between agents- extrapolators and other agents? Could the bubble be caused by such irrationality as extrapolative expectations? 1. Literature overview Over the last 20 years there has been an increasing amount of research made on the stock markets studying the importance agents’ beliefs irrationality. The paper by De Long, Shleifer, Summers and Waldmann (1990) implies that the deviation of actual price from its fundamental value is explained by “ unsophisticated” investors opinion. The aim of their work was to account significant evidence of extrapolation, found in data, in the existing aggregate stock market models. As the result, the new model was better at explaining the reality than the traditional ones, which did not consider irrational expectations. One of the interesting findings made by authors is that fundamental investors account for the strategy of extrapolators: they realize that the latter’s future strategy tightly depends on the past performance of the stocks. As the result, fundamentals do not counteract aggressively to the extrapolators’ actions, because they expect these actions to last for some time in future. My work differs from one by Barberis, Greenwood, Jin and Shleifer (2013) for not accounting the abovementioned “smoothing” strategy of fundamental investors.
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