FIN 405 Week 4 Market Anomalies and Bubbles Example

Overreaction, Momentum and the Nasdaq of 2000: Testing Market Anomalies Against the Efficient Market View and Asking Whether the AI Rally of 2023-2024 Fits the Pattern

[Student Name]

University of Phoenix

FIN/405: Behavioral Finance

Week 4 Assignment

[Instructor Name]

[Date]

The investment committee is a composite written for a model paper; index levels, dates and research findings come from the public record and the sources listed.

The investment committee of a composite community foundation in Minnesota oversees a $210 million endowment. After a strong rally in technology stocks during 2023 and 2024, driven largely by enthusiasm for artificial intelligence, technology made up 34 percent of the endowment's equity holdings, compared with 24 percent two years earlier. Two committee members wanted to sell technology because they believed it was a bubble; two others wanted to buy more because the trend was strong. The chair asked the staff for an analysis grounded in research. The question was not whether anyone could time the market, but what the evidence on anomalies and bubbles implied for a committee that cannot. This paper provides that analysis.

What Counts as an Anomaly

An anomaly is a pattern in returns that a model of expected returns does not explain. Because the test depends on the model, every anomaly raises a joint question: either markets misprice the pattern or the model leaves out a source of risk. That point, emphasized in the efficient markets literature, keeps the debate honest. A pattern can be real and still not be a profit opportunity if it reflects risk or disappears after trading costs.

Overreaction

De Bondt and Thaler (1985) formed portfolios of the stocks with the most extreme returns over the previous three to five years. Over the following years, the prior losers outperformed the prior winners by a wide margin, a result they attributed to investors overreacting to news, extrapolating good and bad results too far into the future. Critics argued that the losers were riskier and smaller companies and that part of the effect clustered in January. Even so, the pattern matched the behavioral idea that investors extrapolate trends.

Momentum

Jegadeesh and Titman (1993) found the opposite pattern over shorter horizons. Stocks that had performed best over the past three to twelve months continued to outperform over the next three to twelve months, and recent losers kept underperforming. Momentum has proved one of the most persistent anomalies across markets and asset classes. Behavioral explanations include slow reaction to news followed by later overreaction; risk-based explanations remain debated. Momentum also suffers occasional crashes, sharp reversals when markets turn after a decline.

Do Anomalies Survive Publication?

Once a pattern is published, investors can trade on it. Studies of many published anomalies have found that their returns fall substantially after publication, consistent with mispricing that informed traders partly correct. That evidence argues against building a strategy on a historical pattern alone.

The Nasdaq Bubble

The Nasdaq Composite closed at 5,048.62 on March 10, 2000, after rising roughly fivefold over five years. By October 2002 it had fallen about 78 percent from that peak. Many internet companies with no profits had traded at valuations that assumed decades of rapid growth. Shiller (2015) described the features of such episodes: a story that a new era has arrived, rising prices that draw in new investors who buy because prices have risen, media attention that amplifies the story and expanding participation by individuals and institutions. Each appeared in the late 1990s, along with initial public offerings that doubled on their first day.

Limits to Correction

Skeptics at the time faced a problem. Fund managers who avoided technology in 1998 and 1999 trailed their benchmarks badly, and some lost clients before the crash vindicated them. Being right too early was costly, which is why bubbles can grow even when many professionals doubt them.

Comparing the Recent Rally

The committee's question was whether the artificial intelligence rally fits the pattern. There are similarities: a powerful new-era story, concentration of gains in a few large companies and strong participation. There are also differences. The largest companies in the recent rally earn large, growing profits and generate substantial cash, unlike most internet companies in 1999, and their valuations, while high, have not reached the extremes of the Nasdaq at its peak. An honest conclusion is that the rally contains bubble-like features alongside real earnings growth, and no one can know in advance which will dominate.

The Housing Boom as a Second Test

The housing boom of the 2000s offers a second case with different mechanics. National home prices roughly doubled between the late 1990s and 2006, supported by a story that home prices never fall nationally, by loans made with little documentation and by securities that spread mortgage risk widely. When prices fell, losses spread through banks and funds that had borrowed heavily against mortgage securities, producing the financial crisis of 2008. Compared with the Nasdaq episode, the housing bubble involved far more borrowing, which made its collapse more damaging to the wider economy. For the committee, the comparison suggested a question to ask about any rally: how much of it is financed with borrowed money, and who would be forced to sell if prices fell?

What the Committee Should Do

The evidence offers the committee a policy rather than a forecast. The endowment's investment policy already sets a target for equity holdings by sector through a broad index and ranges around asset class targets. The staff recommended rebalancing the overall equity allocation back to target whenever it drifts more than five points, which would trim the winners automatically, and declining to make a separate bet against technology. Rebalancing sells some of what has risen without requiring the committee to declare a bubble, and it buys what has lagged, a disciplined way to benefit from long-term reversal if it occurs while keeping exposure to momentum if it persists.

A Note on Humility

Members who wanted to sell everything and members who wanted to buy more both claimed confidence about the future. The research on anomalies and bubbles supports neither form of confidence. Its most reliable lesson is that markets sometimes misprice assets but that profiting from mispricing is difficult, costly and uncertain in timing.

Conclusion

Overreaction and momentum show that returns can depart from what simple models predict, though risk explanations and fading after publication complicate the picture. The Nasdaq collapse of 2000 displayed the features of a speculative bubble. The current rally shares some of those features and differs in others. A rebalancing rule lets the committee act on what the evidence supports without betting on what it cannot predict.

References

De Bondt, W. F. M., & Thaler, R. (1985). Does the stock market overreact? The Journal of Finance, 40(3), 793-805. https://doi.org/10.1111/j.1540-6261.1985.tb05004.x

Jegadeesh, N., & Titman, S. (1993). Returns to buying winners and selling losers: Implications for stock market efficiency. The Journal of Finance, 48(1), 65-91. https://doi.org/10.1111/j.1540-6261.1993.tb04702.x

Shiller, R. J. (2015). Irrational exuberance (3rd ed.). Princeton University Press.