Asset Float and Speculative Bubbles

We model the relationship between asset float (tradeable shares) and speculative bubbles. Investors with heterogeneous beliefs and short-sales constraints trade a stock with limited float because of insider lockups. A bubble arises as price overweighs optimists’ beliefs and investors anticipate the option to resell to those with even higher valuations. The bubble’s size depends on float as investors anticipate an increase in float with lockup expirations and speculate over the degree of insider selling. Consistent with the internet experience, the bubble, turnover, and volatility decrease with float and prices drop on the lockup expiration date. THE BEHAVIOR OF INTERNET STOCK PRICES during the late 1990s was extraordinary. On February of 2000, this largely profitless sector of roughly 400 companies commanded valuations that represented 6% of the market capitalization and an astounding 20% of the publicly traded volume of the U.S. stock market (see, e.g., Ofek and Richardson (2003)).1 These and similar figures led many to believe that this set of stocks was in the midst of an asset price bubble. In turn, the valuations of these stocks began to collapse shortly thereafter and by the end of the same year, they had returned to pre-1998 levels, losing nearly 70% from the peak. Turnover and return volatility in these stocks also largely dried up in the process. The collapse of internet stock prices coincided with a dramatic expansion in the internet companies’ publicly tradeable shares (or float) (see, e.g., Cochrane (2003)). Since many internet companies were recent initial public offerings (IPOs), typically as 80% of their shares were locked up—shares held by insiders and other pre-IPO equity holders are not tradeable for at least 6 months ∗The authors are from the Department of Economics and Bendheim Center for Finance, Princeton University. Scheinkman and Xiong are also affiliated with the NBER. We thank the National Science Foundation for financial support. We also thank Alon Brav, Itay Goldstein, Rodrigo Guimaraes, Lasse Pedersen, Jay Ritter, Rob Stambaugh, Jeremy Stein, Dimitri Vayanos, and especially an anonymous referee, as well as seminar participants at the Association Française de Finance Meetings, Columbia University, DePaul University-Chicago Federal Reserve, Duke University, HEC, INSEAD, the National University of Singapore, the NBER Asset Pricing Meeting, New York University, SEC, University of Florida, University of Iowa, Université Paris-Dauphine, the Western Finance Association Meetings, and the Wharton School for their comments and suggestions. 1 The average price-to-earnings ratio of these companies hovered around 856. Moreover, the relative valuations of equity carveouts such as Palm/3Com suggest that internet valuations were detached from fundamental value (see, e.g., Lamont and Thaler (2003), Mitchell, Pulvino, and Stafford (2002)).