Download The 2007/2008 financial crisis came with a strong fall in stock prices

BELIEF IN THE ‘GREAT MODERATION’ DROVE THE STOCK MARKET BOOM
BEFORE THE CRISIS
Overconfidence in the stability of the economy in the years leading up to the financial
crisis can account for up to 80% of the boom in share prices that preceded the bust.
That is the conclusion of new research by Tobias Broer and Afroditi Kero, to be
presented at the Royal Economic Society’s 2012 annual conference.
Their study presents the following argument:

The fall in the volatility of economic growth that persisted throughout the 2000s
led commentators to call it the ‘Great Moderation’.

As it continued, investors became more and more confident that this new
economic calm might be permanent. This confidence increased their appetite for
traditionally riskier investments, such as shares.

This increased risk appetite can explain the rise in share prices by up to 80%
until the mid-2000s.

The return of macroeconomic volatility following the collapse of Lehman Brothers
in late 2008 helps to explain the large drop in share prices.
More…
The 2007/08 financial crisis put an end to an extraordinary period of financial market
expansion that started in the late 1980s. In this study, Tobias Broer and Afroditi Kero
observe that this boom in asset prices roughly coincided with a period of
macroeconomic tranquility (later called the ‘Great Moderation’), which was
characterised by significantly lower volatility of GDP growth.
As the authors argue, the rising confidence in this calm economic environment might
explain a large part of the observed boom in stock prices. And the realisation that
tranquil times were over in 2007/08 may be an important factor behind the drop in asset
prices, and financial market retrenchment more generally, that followed.
The paper starts with the observation that both academics and market participants
were aware of a moderation in macroeconomic fluctuations in the US and elsewhere as
early as the mid-1990s, but unsure about its persistence. In fact, research at the time
pointed to both temporary factors as well as permanent structural change (through for
example, new just-in-time inventory management) as reasons for the fall in output
volatility.
To analyse how this uncertainty, and learning about the persistence of the new ‘Great
Moderation’-era, may have affected financial markets, the authors analyse a scenario
similar to the US post-war experience. As an observed fall in the volatility of aggregate
output persists, investors become more and more confident that this new economic
calm might be permanent. This confidence strongly increases their appetite for
investments such as stocks, whose riskiness rises and falls in line with aggregate
economic fluctuations, relative to safe bonds or bank deposits.
The authors show how this increased risk appetite can explain a rise in stock prices by
up to 80% until the mid-2000s, as investors became increasingly confident that lower
volatility was ‘here to stay’. Moreover, if the crisis of 2007/08 came with a suspected
return to the high macroeconomic volatility of the 1960s and 70s, this explains a large
drop in asset prices.
The authors also explore some related alternative mechanisms that may have
contributed to the asset price boom. For example, ‘quantitative’ investment methods,
which rely heavily on historical data to form expectations about risks in the future, can
lead to an even stronger rise in risk appetite of investors during a long period of
economic calm.
ENDS
‘Great Moderation or Great Mistake? Can rising confidence in low macro-risk explain
the boom in asset prices?’ by Tobias Broer and Afroditi Kero