What is a bubble?

A comprehensive new study from Harvard University goes a long way toward delineating the nature of stock market bubbles:

We evaluate Eugene Fama’s claim that stock prices do not exhibit price bubbles. Based on US industry returns 1926-2014 and international sector returns 1986-2014, we present four findings: (1) Fama is correct in that a sharp price increase of an industry portfolio does not, on average, predict unusually low returns going forward; (2) such sharp price increases do predict a substantially heightened probability of a crash; (3) attributes of the price run-up, including volatility, issuance, book-to-market ratio, market P/E ratio and the price path of the run-up can all help forecast an eventual crash; and (4) some of these characteristics can help investors earn superior returns by timing the bubble. Results hold similarly in US and international samples.

Our broad conclusion is one that historians – particularly Kindleberger — have reached already. There is much more to a bubble than a mere security price increase. There is innovation, displacement of existing firms, creation of new ones, and more generally a “paradigm shift” as entrepreneurs and investors rush toward a new Eldorado. Our contribution is to show that this shift is to some extent measurable in financial data, so one can also identify – imperfectly but well enough to predict returns – asset price bubbles in advance.

Kudos to Greenwood, Shleifer, and You for this important work.

The precise definition of a bubble, of course, will always remain elusive.  The market is a human construct, so at some level we’re stuck with Stewart Potter’s definition of pornography: “I know it when I see it.”

Justice Potter’s famous remark reminds us to consider the white space.  Bubbles are hard to define.  But we can possibly know what isn’t a bubble.  The NASDAQ Composite, for example, is currently trading in an orderly fashion (Charts 1 & 2).  And since an orderly trend is not a bubble… well, you get the point.

To our way of thinking, the NASDAQ is no bubble – at least not yet.

Chart 1. NASDAQ price history

Chart 2. NASDAQ versus S&P 500

By | 2017-05-04T13:13:18+00:00 May 4th, 2017|Categories: Market Strategy Report|0 Comments

About the Author:

Mark Ungewitter is a Senior Vice President & Investment Officer at Charter Trust Company. He was formerly Director of Portfolio Management at Investors Bank and Trust in Boston, Massachusetts. He holds an M.S. from Bentley University and a B.S. from Massachusetts College of Liberal Arts. He is a member of the American Association of Professional Technical Analysts.

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