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Is rally result of irrational investors?

The stock market has come back from the dead, with the Standard & Poor's 500-stock index up 13 percent so far this year. Even the formerly moribund technology sector is reviving, with the Nasdaq showing a 26 percent return since January.

According to a recent New York Times article by Gretchen Morgenson, much of this renewed vigor is driven by retail investors. Is this a rational response to undervalued technology stocks, or the start of another bubble?

To gain some perspective, it is helpful to examine a recent post-mortem on the dot-com boom by two professors at New York University's Stern School of Business, Eli Ofek and Matthew Richardson. Their article, "DotCom Mania: The Rise and Fall of Internet Stock Prices," was published in the June 2003 issue of the Journal of Finance.

The authors' explanation for the bubble has two components. First, there were significant differences of opinion about the value of Internet stocks, with retail investors tending to be much more optimistic than insiders or institutions.

Second, there were significant restrictions on short-selling those stocks, or betting that they would decline. This prevented the pessimistic expectations from being incorporated in market prices. The result was that Internet stock prices were biased upward, with all-too-familiar consequences.

This story, or variations on it, is widely held to be a plausible explanation for the bubble. The contribution of Ofek and Richardson was to assemble a mass of detailed evidence that supports this analysis.

Much has been written about the betrayal of the small investor. But dot-com shareholders made no bones about the fact that they were selling. After all, that's what an initial offering is: insiders selling shares to outsiders.

Of course, there is no excuse for fraud and misrepresentation. But if those in the best position to know the long-term value of a stock were so anxious to sell, one would think that would convey the message that dot-com valuations were too high. The market eventually got that message, but it took a long time.

What lesson can we draw from the Ofek-Richardson account about the current revival in tech stocks? It is that constraints on short-selling are still with us, and the market is still susceptible to irrational exuberance on the part of small investors.

Unfortunately, according to the Morgenson story, it is the most speculative stocks _ biotech, Chinese Internet and penny stocks _ that are showing the biggest price surges, and most of the interest appears to come from individuals. Analysts, whose views might be more representative of institutional investors, appear to be sitting on the sidelines.

If this pattern persists, it does not bode well for the current tech recovery.