The Trouble With Bubbles

Includes: AGG, DIA, SPY
by: James Picerno

What's the difference between a bubble and a legitimate rise in prices? Fundamentals, or so the story goes.

Paul Krugman speaks for many when he writes that the boom in housing early in the decade was a bubble. But something similar in crude oil wasn't a bubble, he opines:

"Oil prices did spike to triple-digit levels in early 2008, then drop sharply. But think about the fact that right now, with the world economy still seriously depressed, oil is at $80 a barrel. This suggests to me that high oil prices are largely caused by fundamentals."

He doesn't detail what he means by "fundamentals," but let's assume he's referring to the source of the higher oil prices as a function of higher demand. But surely that was part of the housing boom equation too. Ah, but the housing boom was supported by an innovative financial sector, along with low interest rates and government policy that promoted home buying. Oil does have Opec, of course, but that's another story.

If you're looking for a hard and clear definition of bubbles vs. bull markets driven by fundamentals you'll have a long wait. Yes, some analysts use models to decide that a given market is in bubble territory or undervalued. This is popular in the stock market, using price-earnings ratio, for instance. Of course, buying and selling solely on p/e is no short cut to riches. In fact, you probably won't earn much more than average by trading exclusively on p/e, even if it's helpful at times. We need to look at othe metrics, as well as monitor the business cycle, the ultimate driver of risk premia. When the stock market's at a "high" p/e, it may be tempting to call it in bubble territory. Reasonable, perhaps, but hard to prove. Meantime, how long do we have to wait for a price correction before we can say a bubble diagnosis was accurate?

Any measure of a bubble depends on a model. If it doesn't yield an outsized return, is the model broken? Or maybe the market's inclined to stay in bubble territory. Hard to tell in real time.

Perhaps, then, bubbles should be thought of as a twist on Justice Potter Stewart's famous observation about pornography: difficult to define, "but I know it when I see it."