Defining a Bubble

Justin Fox writes,

So maybe we should tweak the second sentence of Brunnermaier’s definition, to something like: Bubbles arise if the price far exceeds the asset’s fundamental value, to the point that no plausible future income scenario can justify the price. A little clunky, and of course “plausible” is a judgment call. But it does get at the idea that we shouldn’t be calling every last rise in P/E ratios a bubble.

Pointer from Mark Thoma.

I would tweak this definition back in Shiller’s direction. I think you have to know why people are buying the asset in order to know whether it is a bubble. If investors who are buying the asset have estimates of the discounted present value of the income from that asset that imply a negative real return, then it is a bubble.

To simplify, assume no aggregate inflation. That gets out of the way any difference between real income and nominal income or between real returns and nominal returns.

Suppose that I buy an asset that yields an income stream–rents, dividends, or what have you. Suppose that we discount this income stream at the risk-free rate, and the resulting real return is negative. Why, then, am I buying the asset?

1. Perhaps it has a “negative beta,” so it has tremendous diversification value. Let’s rule that one out.

2. I get utility out of owning the asset. This might apply to jewelry or paintings. Or I could get “extra utility” out of owning my house that is over and above what I save by not having to pay rent. Let’s ignore those cases, also.

3. I expect to be able to sell the asset at a higher price to someone else.

When (3) is the only way to get a positive return from holding the asset, then we have a bubble.

The difference between my definition and Fox’s is that his definition requires that we have an objective definition of “plausible.” Mine requires learning from investors what their estimates are for future income from the asset.

So with something like stocks, you have to know whether the people buying are projecting higher future earnings than what you think are plausible (in which case, no bubble) or whether they are projecting earnings that imply negative rates of return (in which case, bubble).

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7 Responses to Defining a Bubble

  1. David N says:

    I think the defining characteristic of a bubble is that there is the traditional methods of valuing assets struggle to justify the price level, and a new explanation or innovation in valuation methods is created. EBITDA. New “paradigms.” This time it’s different.

  2. Fonzy Shazam says:

    I think your method is going to get a lot of false positives. Many, many investors in stocks don’t do their own projections of future cash flows. They rely on others to do that work assuming there is an underlying rational case for buying a stock that changes over time–meaning many investors don’t understand the idea that current prices reflect the present value of ALL FUTURE EARNINGS. Their purchases are essentially bets that the future will be brighter than the balance of the evidence suggests. I don’t think unintentional gambling or misunderstanding of how market asset pricing works should imply asset prices are in a bubble.

  3. Yancey Ward says:

    You can try to learn from “investors” what their return metrics are, but I think they would just tell you whatever lie they told themselves to justify the purchase in the first place.

  4. guybellingham says:

    Justin Fox writes we shouldn’t be calling every last rise in P/E ratios a bubble.

    I agree. The current stock market is terrifically overvalued having been in a bubble for quite some time.

    Just about the only stock that has fair market value is Barrick Gold with a PE of 9.

    Its weekly chart shows it to be in an Elliott Wave 3 up

    Its daily chart shows this to be an Elliott Wave 3 of 3 up

    In the case of Real Estate, I live in Bellingham WA where housing values are largely driven by anticipation from rental values. If we look at “I expect to be able to sell the asset at a higher price to someone else”, then given my expectation of a soon coming economic downturn, I would not buy any real estate, because I might even be able to rent the property out.

  5. andrew' says:

    You can tell a bubble by the “pop!”

    You also usually need credit.

  6. bjk says:

    A bubble is any asset for which the incremental buyer is relying on the greater fool theory for price appreciation.

  7. Handle says:

    bjk has a good definition.

    A bubble exists in a market when prices are rising because the trading dynamics become uncorrelated from ‘fundamentals’ (projected income streams) and instead correlated with the activity of speculative ‘flippers’ looking for greater fools.

    Flippers don’t know and don’t care why prices are going up. They figure that rising trends tend to continue in the short term, and that they can get in and out before the trend reverses.

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