During the Nasdaq tech bubble, most people I knew thought it was unsustainable. Yet, at the same time we all hated to miss a big move. We knew we were going to get burned. We also assumed we could get out on time. I am correct in my assumptions or did investors really believe this would continue in the indefinite future? (Bob Zdanky, Noblesville, IN, USA)

Your description fits well with the “story” of my work “Was there a Nasdaq Bubble in the Late 1990s?” (with Lubos Pastor, JFE 2006). If you decided to take a long position in tech stocks because “we all hated to miss a big move” you must have thought that there was some chance that stocks were not overpriced. Otherwise, if you knew it was unsustainable for sure, why not short tech stocks? If you knew it was unsustainable, a short position should have been the only reasonable strategy (and indeed, it would have paid off, ex post). You did not short it because you did not think it was surely the case that it was unreasonably high (in economics, this is called “revealed preferences,” that is, there is more information about yourself in what you do than in what you say).

In our paper, Lubos and I argue that stock prices go up when there is a reasonably large idiosyncratic uncertainty about long term growth of a company or a sector. For instance, a company that has 50-50 chance of growing at 20% or 0% is much more valuable of a company that has 100% chance of growing at 10% per year. To put it in the words of Bill Miller, a portfolio manager of the Legg Mason Value Trust, who used similar logic to justify the valuation of Amazon.com in 1999: “...being wrong isn’t very costly, and being right has a high payoff... With Amazon, we believe the payoff for being right is high.” (“Amazon’s Allure...”, Barron’s, November 15, 1999).

My impression of the late 1990s was that most VCs and investment bankers were quite cynically unloading what they knew were bad deals onto an investing public that was naive about technology stocks, and in too much of a state of greed-induced euphoria to apply common sense. Are you sure that uncertainty about future profitability can enhance the value of a deal? (Samantha Prescott, Reno, NV, USA)

Your point about VCs and investment bankers is a commonly shared view of the late 1990s. However, the “naïve investing public” included many relatively sophisticated institutions that got burned when the “bubble burst”. Moreover, I always urge investors and others to think deeply about other facts that surrounded the 1990s. If it was just the fact that there was a “greed-induced euphoria”, then prices should have gone up, period.

Instead, the late 1990s saw numerous additional facts about stock prices and investors behavior, which are harder to reconcile with the simple euphoria (or over-optimism) story: (1) The volatility of tech stocks was much higher than non-tech stocks and increased in the late 1990s exactly when stock prices increased; (2) the risk of these stocks was initially low and increased as prices increased, and finally peaked about one year after Nasdaq peaked; (3) the Nasdaq’s decline occurred exactly the year (2000) when earnings of tech firms dipped compared to the past (i.e. one should not be surprised to see prices decline when there are bad news about earnings).

In contrast, all of these facts are consistent with the view that the late 1990s were characterized by large uncertainty about future growth springing from the difficulty in gauging the long term effects of the IT revolution that was taking place.

Do you share Prof. Shiller’s view that the media should be blamed for making investors believe, in the 1990s, that prices would have gone up forever and a new economic era was dawning?

The media is generally better at telling stories about why things have happened than at forecasting what is going to happen. Some individuals are certainly fooled by the occasional media frenzy. However, it seems hard to believe that institutional investors such as pension funds, mutual funds, etc. would be fooled by journalists. I also comment on the new era story below.

Why are technological revolutions historically associated with stock markets overreaction - I mean, high price increases followed by sudden busts? Can the government do something to avoid such wide swings? (David Churchyard, NJ, USA)

In a new paper (“Technological Revolutions and Asset Prices”, NBER WP, 2005) my colleague Lubos Pastor and I propose a simple theory to explain the rise and fall of asset prices during a technological revolution. This theory relates to the changing nature of risk that new technologies bring about. Consider an example first: think back to 1995, and think about what would have happened to the world economy if hackers successfully attacked the Internet and brought it down for a month. Would you or anyone else have cared about it? Of course not. The worse that it could have happened was that you could not send a couple of emails, and Amazon could not sell its books.

If today, in 2006, the same hackers attacked Internet and brought it down for a month, would you care? Most likely yes. Now this technology (part of the IT revolution at the end of the 1990s) is so widespread and used to produce real goods and foster economic growth, that if it were to be successfully brought down, it would have a serious effect on the world economy. In financial terms, the risk of the new technology moved from idiosyncratic (affects only a small fraction of the economy) to systematic (it affects everyone). As any student in finance knows, high systematic risk implies high expected returns which in turn implies lower prices. Lubos Pastor and I argue that every technological revolution has, by its very nature, an implication on the dynamics of risk, which passes from idiosyncratic to systematic, and therefore ultimately generates a downward movement in prices.

Can investors benefit from our insight? No: we know now that Internet has generated a revolution, but we did not know in 1995 whether it would. This pattern of stock prices during a tech revolution is only observable ex post, after we saw the revolution, but it is unpredictable ex ante, as we only attach a probability to the event that a new technology will be successful and a technological revolution will take place.

In this light, should the government do anything about price swings? No. The government should not touch asset prices. Do we really believe that government officials know more about the proper level of stock prices than sophisticated financiers whose wealth is at stake? New entrepreneurs and investors are lured to innovate and invest in new technologies in part because they expect to sell their firms/patents in IPOs with a good return on the risk they took. The high prices around technological revolutions simply provide the right incentives for new ideas to be explored and experimented. Any intervention of the government may impair this fundamental function of the stock market, and therefore, eventually, affect economic growth.

During the last few years the market for tech stocks has rebounded and we now see many IPOs, but underpricing seems to be much less pronounced now. Why? (Marie Hertz, Mannheim, Germany)

Yes, The Economist (September 22, 2005) has called it “Bubble 2.0.” Once again, there is the tendency of the media and some economists to keep talking about a bubble whenever prices go up. Yet, such prices may well be rational, and just reflect the earnings potential in the new technologies. We should remember that there were stocks in the past that sustained extremely high earnings for very long time. For instance, Microsoft and Oracle had an astonishing 44% and 47% average profitability for 12 years in a row, respectively. Dell and Cisco had similar numbers for 10 years.

In fact, if we go back in time, entire industries had been doing extremely well for prolonged periods: the pharmaceutical industry earned over 25% average profitability for 45 years, the candy and soda, and tobacco industries earned similar average profitability for 36 years in a row. To put it differently, the mere possibility of experiencing very high earnings growth makes a firm very valuable.

The first-day IPO underpricing has gone down, probably in part due to the closer regulatory attention aimed at the IPO allocation process.

Your study finds that the tech bubble of the 1990s was associated with great uncertainty about firms' future profits. Does this entail firms with a less uncertain future only should be allowed to go public? (Alfred Thompson, Ottawa, Canada)

No. Uncertainty about firm-specific growth is good and the high market valuation that it entails is at the heart of the incentives of good entrepreneurs to explore new ideas and experiment new technologies. If we were to only allow companies with a certain growth and no “option value” to go public, we would damage the key role of the stock market to allocate resources from those who have them (investors) to those who need them (entrepreneurs) as a compensation for the risk they take to innovate. Ultimately, if entrepreneurs are so prevented from taking the risk of innovate and experiment new ideas, the whole economy will suffer.

Of course there is always the possibility of “bad” entrepreneurs with no ideas to mix themselves with the good ones, and this may generate some sour stories and bad return on investments. The need of some control is important. But most definitely we do not want to shun from the markets those who have ideas that may be revolutionary: there is a lot of uncertainty, of course, but this comes naturally with any new idea or new product.

Google has a market capitalization larger than those of Yahoo! and Apple combined. Yahoo! provides a range of services similar to that of Google of oftentimes comparable quality, while Apple has a foothold in innovative hardware that Google doesn't. Is Google a "bubble" stock for the Noughties?

The stock price of a firm depends in part on the possibility that that firm will generate an extremely high growth in the future. Perhaps exactly because there is still some uncertainty on the type of potential in Google, which proved itself as one of the most innovative firms in the last decade from many points of view, its price is richer than the much older Apple and the already mature Yahoo!. To put it differently, we have already learnt much about the potential of Yahoo! and Apple (although Steve Jobs manages to surprise us, still), but the stock price depends on what a firm could do in the future. And this option value seems higher for Google than for the other firms in the mind of investors.

As someone who reads a great deal on the Internet, I get the impression that there is an economic Tsunami approaching the American shores. It has to do with the declining dollar, an ascending euro, an Iranian Oil Bourse, Russian oil purchases, a rush to buy gold, the replacement of the dollar as the world's currency of choice, etc. Is all this Internet reportage wishful thinking on the part of America's numerous enemies? Or, has America become the proverbial ostrich with its head in the sand to keep from seeing the approaching danger? (Alan Weber)

I seriously doubt that the United States is in any danger of an “Economic Tsunami”, at least not in the short run. There are definitely some worries about some issues, such as the large budget deficit and the large negative foreign balance. But the economy is growing fast, and faster than many other Western economies, with a relatively small unemployment rate and low inflation. In the longer run, much will depend on some key policy issues, such as energy policy, for instance. If there is a Tsunami coming, I think it is still quite far away from USA shores.

With all the money pouring into private equity and venture capital these days, are we headed towards another bubble? Also, where is all this liquidity coming from? And where was all this money invested say 3 years ago? (Usman Haque, Lahore, Pakistan)

I do not believe there was a bubble in the 1990s to start with, so “no, we are not headed towards another bubble.” Indeed, the repetition of facts just occurred recently is a good indication that the 1990s were not a bubble at all. It is hard to believe that investors have already forgotten what happened just 6 years ago. If you think of what stocks now are hot, we are talking again of stocks that may potentially lead to a new technological revolution, such as Nano tech stocks.

The world is awash with liquidity at least in part due to the relatively low interest rates worldwide.

Where was all this money invested 3 years ago? This money may not have existed 3 years ago. Finance is not a zero sum game. The world as a whole got richer over the past three years (just look at the rising real estate prices), and some of the new wealth has been directed towards private equity, along with some of the old wealth.