I Read Academic Research So You Don't Have To: Technology Revolutions and Stock Prices

by Ann C. Logue

One of the advantages of mutual fund investing is automatic portfolio diversification, which insulates investors from the worst of the market extremes.  Of course, this is a disadvantage when certain market sectors are going up, because mutual fund investors miss out on the fun while it lasts.

Whether it’s subprime mortgages, Internet pet food retailers, or instant photography companies, the markets follow an almost predictable cycle when looking at new technology: people are afraid of it and then they fall in love with it.  Eventually, they realize that the market isn’t as enormous or risky or fast growing as they once thought, and the whole things comes crashing down while investors move on to the Next Big Thing, whatever that is.

In their paper “Technological Revolutions and Stock Prices,” (http://faculty.chicagogsb.edu/finance/papers/SSRNid868527%5B2%5D.pdf) Lubos Pastor and Pietro Veronesi of the University of Chicago’s Graduate School of Business come up with an explanation for how stock prices change as a new technology rolls out.  To do this, they look at American railroads, which haven’t been considered disruptive technology for about 150 years or so.  Their stocks were hot for a while, until the bubble burst in 1857. Pastor and Veronesi found detailed stock price records (the New York Stock Exchange opened in 1792) and historical documents to track what happened.  Because it took longer for technological changes and information to be spread back then, it’s easier to track what changes took place when.  By contrast, the entire dot com bubble expanded and popped in about five years, making it tougher to tease information out of the data.

The researchers pulled up stock price and volatility data on 41 different steam-powered railroads in operation between 1830 until 1860, and then compared that to the New York Stock Exchange as a whole.  What they found was that in the early years, when steam power was new and people weren’t even sure if it was safe for humans to travel at speeds of 30 miles per hour or so, the companies had idiosyncratic risk.  Their risk levels reflected their own businesses, not that of the market.  Prices in this early era were high relative to book value and showed great volatility.  Then, as people used steam railroads more and more, the risk in these stocks started to become closer to the risk of the market.  The idiosyncratic risk went down, and so did stock prices relative to book value.  Eventually, railroads became commonplace, and there was little risk left to investing in them. That caused the prices to crash.  Although one might think that stock prices would keep rising with revenue once everyone took the train everywhere, that’s not what happened.  When the railroads were no longer risky, investors expected lower returns and lower prices.  They took their money elsewhere in an attempt to keep getting the high returns they had made when railroads were risky.

While putting their research together, Pastor and Veronesi made a few provocative statements about new technology.  The first is that it is exogenous.  That is, it’s a force that comes from outside of the current economy, rather than a development within it.  When a new technology is introduced, it replaces the old technology.  It’s difficult to go back, but there’s no guarantee that the new technology will be more productive than the old one.  It may well be less productive, especially when learning costs are considered.  That raises the stakes of investing in it.  Of course, the riskier investment leads to high expected returns should it work.  And that’s something to consider when looking for the Next Big Thing to invest in.

Unfortunately, this paper shows the limits of academic work on practical investment topics.  It’s interesting, but it has no information in it that can help someone get a fix on when a bubble is inflating and when it’s about to pop, crucial information needed to time the purchase and sale of a security. We’ll have to wait for the next paper on the next bubble in hopes of gleaning practical help.  In the meantime, investors have more ways to think about how the risk of a new invention or idea changes over time, which might help them avoid the worst of the fallout.

If you’d rather contemplate bubbles through a lighter medium than a finance professor’s working paper, check out the YouTube videos of The Richter Scales, an a capella singing group from San Francisco (www.richterscales.com).  They have two songs, “Fine Line: Sub-Prime Decline” and “Here Comes Another Bubble,” available for your viewing and legal-downloading pleasure.

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