Monday, March 19, 2012

Castles In The Air Vs Firm Foundation Theory

When determining the price of stock investors often rely on “The Firm Foundation Theory” or “The Castles in the Air Theory” which have contradictory connotation associated with stock market bubbles. Stock Market bubbles are abnormal increases in market value followed by leveling drop. “The Firm Foundation Theory” uses formulas and past information to determine stock prices, so when abnormal fluctuation takes place it will have a contrasting effect. “The Castles in the Air Theory” base it profit making on predicting what the other buyers will do and thus often searches for the formation of bubble.

The term bubble when applied to the stock market refers to an overpriced stock. An economic bubble is “trade in high volumes at prices that are considerably at variance from intrinsic values.” (King, Ronald R). A stock market bubble is a type of economic bubble that occurs when investors overvalue a stock the price rises above the normal stock valuation in a short periods of time. This is because there is a misconception about the stock and people keep paying more than the last trade of already overvalued stock. This goes on till the stock eventually crashes. Thus, like a bubble, the stock quickly grows and then pops and crashes.

Malkiel examines the Mississippi Scheme in France and the South Sea bubble in England, famous stock market bubbles than came to a sudden end in 1720 bankrupting thousands of misguided investors. Malkiel explains in the case of the South Sea Company good timing and deception where major factors. The English people where eager for investment opportunities in 1711, the year the South Sea Company formed. The company took a government IOU of £10 million for the exclusive rights to trade in the South Seas. People believed massive profits would be made in this monopoly and quickly overvalued this stock. The directors of new company had no experience in South American trade, but made sure to project an image contrary to that. A prominent building in London was rented and dressed to illustrate successes. Though business endeavors ended in failure and war with Spain halted trade prices continued rose. At the same time in France the Mississippi Company was formed. Mississippi stock prices grew exponentially for no apparent reason. People couldn’t buy enough of these companies, the frenzy passed on to other stocks, many emerging simply to feed the demand on investment. The “bubble” popped when South Sea Company directors knowing the stock was overvalued sold. When word of the event got out to the public prices crashed from roughly £950 per share to £150 per share.

Bubbles still a significant in today’s global economy. The period of 1995-2001 would come to be known as the dot-com bubble. Lots of tiny based businesses flourished with funded by venture capital and banks. These investors where looking to cash in on the Internet trend, ignorant the stocks being overvalued. The excerpt below comes from an interview with a yahoo employee.
“I had a front row seat for the Internet Bubble, because I worked at Yahoo during 1998 and 1999. One day, when the stock was trading around $200, I sat down and calculated what I thought the price should be. The answer I got was $12… What made our earnings bogus was that Yahoo was, in effect, the center of a pyramid scheme. Investors looked at Yahoo's earnings and said to themselves, here is proof that Internet companies can make money. So they invested in new startups that promised to be the next Yahoo. And as soon as these startups got the money, what did they do with it? Buy millions of dollars worth of advertising on Yahoo to promote their brand. Result: a capital investment in a startup this quarter shows up as Yahoo earnings next quarter—stimulating another round of investments in startups.” (Graham, 2004).

The dot-com bubble climaxed in March 2000 after the NASDAQ Composite index peaked at 5,048.62. After this peak the market turned bearish and the bubble popped, triggering the “Early 2000s recession” effecting chiefly United States and the European Union. The recession was characterized by large layoffs and outsourcing lasting till approximately to mid-2003.
In an efficient market there should be a price for any asset which buyers and sells agree on. “The Firm-Foundation Theory” proclaims all assets have an intrinsic value that can be calculated with careful analysis. Stocks, bonds, property, and all other investments have a way to discount their Future value to determine the current price. Discounting is the amount needed today so that given an interest rate and an amount of time the investment will grow to one dollar. Discounting is used to determine the Present Value of an investment, in an efficient market this is the price where buyers and sellers agree to trade for a simple asset. The Present Value is of a one dollar is where R is the rate of return and t is the time. Thus, if investing $1000 at 7% for 2 years the Present Value would be $873.44 ($1000/1.1449).

To determine the value of Common Stock is more complicated in Chapter 5, of A Random Walk Down Wall Street, Malkiel says you much first Determine The expected growth rate, The expected dividend payout, the degree of risk, and the level of market interest rates. The growth rate, denoted by g, is the rate at which dividends will increase. So if the dividend just paid is and the next dividend is then . In general, the price today of a share of stock, is the present value of all future dividends.

If this can be condensed if there is a Constant Growth the formula can be condensed.

According to the “The Firm-Foundation Theory” buyers and traders should meet in the market and trade at this price . However, this does not establish the risk involved in the transaction. Total returns are expected return plus the unexpected return, where unexpected returns are risk. Leading to Malkiel’s last Determinate of market interest rates, if the risk associated with a stock is high and returns of that stock are only slightly higher than interest rates (or lower), then buyers would prefer to put their money in banks and bonds where risk is very low.

“The Firm-Foundation Theory” challenges the idea of a stock market bubble. The theory establishes there is an intrinsic value for all assets. However, a theory by Louis Bachelier, “The Efficient Market Hypothesis Theory” published 1900, explains why prices vary. Efficient market hypothesis affirms that financial markets are "informationally efficient". The efficient market hypothesis is commonly stated three different forms: strong form efficiency, semi-strong form efficiency, and Weak form efficiency. If the market is strong form efficiency then all information is reflected in the price. If all information was reflected in the price then risk would be eliminated and “The Firm-Foundation Theory” would hold. In actuality stock markets tend to reflect semi-strong and weak form efficiency. In semi-strong form efficiency all public information is reflected in the stock market and in weak form efficiency there is no relation to past prices, thus no excess returns can be earned by investment strategies. Because new information is constantly becoming available prices constantly fluctuate to reflect all given information. If information is mistaken and bubble forms in the market then the “The Firm-Foundation Theory” cannot hold, because true value is hard to determine and is not reflected in the current market price.

Buyers constantly try to determine future prices base giving birth “The Castle in the Sky Theory”. According to Keynes, a British economist, “the firm-foundation theory” involves too much work and is of doubtful value.” (Malkiel 31). Instead Keynes insisted in predicting the packet’s future movement and staying one step ahead of it. This is the “The Castle in Sky Theory”. Keynes declares a successful investor must analyze where the crowd will invest in the future, where crowd’s optimism will build a castle in the air. “The successful investor tries to beat the gun by estimating what investment situations are most susceptible to public castle-building and then buying before the crowd.” (Malkiel 31). Keynes became very wealthy practicing these ideas. When Keynes died, in 1946, he was worth over £7million.

If a market is efficient then the Net Present Value of any investment should be zero. This is because with all the given information if prices neither too high nor too low, then the difference between the market value and the cost of an investment is zero. Keynes preaches to find positive Net Present Values by determining investments where buyers in the future will determine the market price is too low. This is often done by determining where a bubble will appear. In practice this is incredibly difficult, but prior the South Sea Bubble if an investor could determine future trends then he could have bought securities for “as low as £55 and then turned them in at par for £100 worth of South Sea stock” (Malkiel 38).

In contrast to “The Firm Foundation Theory” that is offset when a bubble arises “The Castle in the Sky Theory” tries to predict when a bubble is forming. “The Firm Foundation Theory” uses trends and applies then to formulas to get expected values of stocks, in hopes to predict profits. “The Castle in the Sky Theory” attempts to profit by determine what other buyers actions will be in the future, often hoping to predict the formation of a bubble. Bubbles have opposite affects on both theories, often negatively for “The Firm Foundation Theory” by counterbalancing data used to get excepted values and potentially positive for “The Castle in the Sky Theory” which attempts to profit by determine the formation of a bubble.


"Efficient market hypothesis." Wikipedia. Wikipedia. 4 Dec 2007 .

Graham, Paul. "What the bubble got right." ICFP (2004):

Jordan, Ross Weasterfield. Fundamentals of Corpate Finance. 8th. New York NY: McGraw-Hill, 2007.

King, Ronald R.; Smith, Vernon L.; Williams, Arlington W. and van Boening, Mark V. "The Robustness of Bubbles and Crashes in Experimental Stock Markets," R. H. Day and P. Chen, Nonlinear Dynamics and Evolutionary Economics. Oxford, England: Oxford University Press, 1993
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