Dissecting Bubbles

 |  Includes: DIA, QQQ, SPY
by: James Picerno

Everybody talks about bubbles, but what should we do about it? Before we can answer intelligently, we need to put bubbles in context. In other words, how should we think about bubbles? There's no simple answer, in part because the hyperbole surrounding the concept is thicker than honey in a beehive.

We can start by considering the argument that bubbles are something strange, something odd, something out of the ordinary. Prices that run up too far and too fast are bubbles, we’re told. The details are debatable, but presumably we all know what a bubble looks like, at least in hindsight, even if we’re reluctant to define it with surgical precision in advance.

Economist Robert Shiller in Irrational Exuberance describes a previous bubble in the stock market as “a situation in which temporarily high prices are sustained largely by investors’ enthusiasm rather than by consistent estimation of real value.”

That sounds like a rare event, although GMO's chief strategist says he's found lots of bubbles in financial history. In a video interview with the Financial Times last week, he reported that his firm identified 34 bubbles in a variety of asset classes over the years. He noted that 32 of them had since fallen back to pre-bubble levels, and that the remaining two that have yet to correct—the housing markets in the U.K. and Australia—are at risk of succumbing to the historical trend. Meanwhile, Grantham says commodities and emerging markets may constitute new bubbles in progress.

Grantham is one of the unofficial gurus on bubbleology and so we take him at his word, i.e, bubbles aren't exactly rare. In fact, they seem downright routine. Ergo, prices go up, prices go down, albeit with varying degrees of volatility within a given time period.

The concept was famously encapsulated by J.P. Morgan more than a century ago, as recounted in Jean Strouse's magnificent biography of "Jupiter," Morgan: American Financier: "Asked to predict what the stock market would do, [Morgan] replied, "It will fluctuate."

And so it shall, along with every other market. A market whose prices do not fluctuate is an unhealthy market. But how much fluctuation is too much? Or too little? The answer depends on your expectations and plans when venturing into Mr. Market's field of dreams.

For traders, there's never enough price volatility. As outlined in Edwin Lefevre's Reminiscences of a Stock Operator, the classic treatise on trading psychology, the fictional Larry Livingston (a thinly veiled front for Jesse Livermore, the famous trader of the early 20th century) tells us:

The tape does not concern itself with the why and wherefore. It doesn't go into explanations… The reason for what a certain stock does today may not be known for two or three days, or weeks, or months. But what the dickens does that matter? Your business with the tape is now--not tomorrow. The reason can wait. But you must act instantly or be left.

Such ideas are anathema to strategic-minded investors, or so-called fundamental investors who look for "value," i.e., assets trading at prices below some estimate of worth. The poster boy for fundamental investing is, of course, Ben Graham, who co-authored the bible for this approach in Security Analysis. To a value investor's sensibilities, the act of trading a la Jesse Livermore is misguided, to say the least. Wall Street Journal columnist Jason Zweig laments the view that traders are a lot that, by definition, trade first and ask questions later. In a recent article that reviews the pros and cons of financial disclosure, Zweig provides a glimpse of Graham's perspective on the subject:

Benjamin Graham, perhaps the most astute analyst Wall Street has ever produced, was once asked whether he thought disclosure was adequate. Graham replied that the quantity of disclosure "makes me ill." He added, "I don't know if there is any solution … I suppose [a prospectus] would have to say in big red-letter words, THIS [SECURITY] IS NOT WORTH WHAT IT IS SELLING FOR. I don't know if that would make any difference either … somebody [would just say], 'What the hell, it is going up anyway.'"

Traders, it seems, are irrational, or so it seems if you're a value investor. The feeling is usually mutual. If so, we've located a key source of why bubbles exist, which are premised on the idea of irrationality, which is a slippery concept depending on who you're talking to. Nonetheless, the bubble itself is widely seen as prima facie evidence of irrational decision making, or so argues the behavioral school of economics. But if bubbles are always and forever irrational, what does that say about the fairly routine arrival of bubbles? Could bubbles simply be part of the normal fluctuation in prices? In a world populated with short-term traders and long-term value investors (a.k.a. "the market"), are bubbles simply inevitable events that reflect disagreement over prices? If so, are these market debates always irrational? Or just natural?

Some economists suggest that bubbles might actually be rational at times. Summarizing one paper in this theoretical corner, Economics 2.0: What the Best Minds in Economics Can Teach You About Business and Life considers the alternative perspective on bubble study via the challenge tied to a lack of time consistency. "The estimation of what will be tomorrow's estimate on long-term price development is not necessarily consistent with today's estimation of long-term price directions," the book explains.

As example, Economics 2.0 asks the reader to imagine a point when most investors believe the market is overvalued. Yet most investors have not yet sold out of the market, perhaps because they expect further price increases, and so they buy more.

"The same will occur tomorrow, with the effect that my daily predictions for the next day's average market assessment will not be in line with my long-term forecast of the average market assessment. The discrepancy grows wider with each day, as observant investors have an incentive to "ride the bubble."

Obviously, the trend evolving this way will be prone to an abrupt reversal. Bits of innocuous public information can bring about a change in direction, for rational investors—rightfully—attach greater significance to publicly available information than to their own, private information. Only public information is meaningful for the formation of investors' average market assessment.

Yet both types of information are unreliable. For instance, an upward blip in the U.S. core inflation may be no more than a slight aberration. If financial markets function akin to Keynes's beauty contests, however, this bit of commonly available information can have very significant consequences. All investors will notice the upward move in inflation rates—and all will know that everyone else sees it, too. As a result, many investors might expect others to sell—and begin to exit their own positions as well. What caused exaggeration on the way up is now likely to cause exaggeration on the way down.

To fully understand the challenge of bubbles, one needs to consider the markets in real time. Indeed, Grantham suggests that commodities and emerging markets may be bubbles. He may be right (or wrong). To be fair, he anticipated the tech bubble that burst in 2000-2002, along with the 2008 reversal of fortunes. Other strategists offered warnings as well. But more than a few value investors went broke in the late-1990s waiting for the bubble to burst. Bubbles exist, but that doesn't mean they can be profitably exploited in real time. Identifying bubble watchers who will be right and timely, in advance, may be just as difficult as identifying the next bubble and when it's set to burst.

We may or may not be in a bubble in one or more markets as we write. If we were sure that a bubble existed, we'd go to 100% cash, wait for the correction and buy anew. In fact, there's a case for embracing this strategy, albeit modestly, in recognition that a) we're never sure if the bubble's a bubble; and b) the timing of the bubble's rise and fall is unknown.

In fact, using the word bubble to describe price changes can get us into trouble. There's a perception that profits come easier in bubbles, either by riding them up or stepping aside when the risk a collapse seems imminent. So be it. Sometimes such analysis is timely, sometimes not. But prices will continue to fluctuate, sometimes violently. This is nothing new.

Perhaps, then, the $64,000 question is: How many bubbles do we need to see in a given time frame before we think of these events as part of the normal market fluctuation? Everyone is likely to have a different answer, which is probably why bubbles will remain a permanent fixture on the economic scene. That's not entirely bad news, as The Road from Ruin: How to Revive Capitalism and Put America Back on Top opines. Why? Bubbles tend to be linked with innovation, this new book argues.

There's a "strong correlation between bubbles and genuinely exciting advances, whether in technology or finance," according to The Road From Ruin. It's not clear, however, that bubbles can be prevented without killing the innovation. Yes, reasonable efforts to keep bubbles under control are warranted, although hammering out the details isn't easy. That's partly because no one's really sure how to prevent bubbles productively without cutting off the economy's nose to spite its face. As economist Russ Roberts has written, "We should face the evidence that we are no better today at predicting tomorrow than we were yesterday. Eighty years after the Great Depression we still argue about what caused it and why it ended." As a result, "We have the same problems in economics. The economy is a complex system, our data are imperfect and our models inevitably fail to account for all the interactions."

Meantime, because the proposed solutions du jour are ultimately political affairs, the danger of making things worse can't be dismissed.

In any case, "we may have to accept some occasional bubbles as a fact of life, human nature being what it is," advises The Road From Ruin, co-authored by Matthew Bishop of The Economist and Michael Green, a London-based consultant and writer. That's not as bad as it sounds, the book argues:

…the really nasty economic consequences tend to result not from bubbles per se but from the wrong reaction when bubbles burst, or when government actions, rather than restraining a bubble, have the effect of blowing air into it. Alas, both of these are common errors.