What is a Bubble, Exactly?

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What is a bubble, exactly?

This may be a silly question to ask, I admit. Everyone knows what a bubble is, right? Yet in my experience, other than someone simply declaring “that’s a bubble,” I have yet to find firm definition of what actually makes a bubble. That is an important point in my mind because simply declaring “that’s a bubble” (1) does not help us understand how the bubble formed and what may cause it to pop, nor (2) does it make me at all confident that this person is correct! I am a “show me your work” kind of guy. I’m not one to accept someone’s declaration as fact.

What’s more, there is a whole line of economic thought that denies the concept of “a bubble” even exists! Nobel-laureate Eugene Fama famously said, “I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.” To be fair to Fama, his point is that the concept is only useful if it helps to make good predictions and you can profit from it. He does not believe the evidence shows that bubble theories are useful for either.

There are some loose frameworks for thinking about bubbles. Of all the bubble theories with which I am familiar a geophysicist, Didier Sornette, applied some earthquake theory to financial markets with reasonable success. Sornette’s bubble theory has the advantage of explicit predictions—he claims to be able to forecast when bubbles will pop to within a few days! (For those less quantitatively inclined, his institute for financial risk at ETH Zurich posts a monthly bubble report that I myself review every month).

Despite its history and obvious utility, I remain skeptical of Sornette’s bubble theory. Just like any other tool in financial markets, there are times it seems to work and times it doesn’t. It is, I think, best used in a mix of tools.

And therein lies my trouble. There is no “mix of tools” when it comes to bubbles.

So, here is my loose framework for thinking about bubbles. There is an important quantitative component which I won’t bore you with here, but an understanding of just the framework is helpful I think.

I think our intuition of bubbles is pretty simple, and can help us with a working definition: something is a bubble when it is fragile with respect to some input. So, for example, through 2001 to 2007, housing prices became fragile with respect to poor underwriting and the proliferation of derivatives. Admittedly, these were obscure inputs to spot, but some financial professionals did spot that fragility and bet on it breaking well in advance of the broader marketplace.

What I like about this definition is that it is about something other than price. Prices going up may or may not be the sign of a bubble. Even if price increases are a symptom of a bubble, that does not help us understand how/why/when the bubble might pop (and prices go down). By focusing on the inputs, we can focus on the underlying problem rather than the symptoms.

This definition also helps us find the source of fragility. Doing a cursory analysis on housing prices in 2006/2007 would not have yielded a satisfying answer—it wasn’t really interest rates or housing supply that was driving the boom, and that should push a dedicated analyst to dig deeper. Once the problem of underwriting and derivatives were found, the source of fragility would be clearer and the analyst could watch those signals for signs of weakness, and thus be prepared for the popping of the bubble.

Financial markets today are quite fragile with respect to economic policy—and have been for the past decade. Markets are generally hooked on the federal reserve and ever-lowering interest rates. This has driven prices across all asset classes ever higher, and created a systemic problem. When the bubble pops, everything pops together.

This means that investors should watch these sources of fragility very, very closely. And remember, prices can stay absurd for a very, very long time. Japan is a good example. They have been running this economic experiment for about 30 years, and it is still going. Most investors simply cannot sit on the sidelines for their entire professional life waiting for a bubble to pop. Thus, understanding the source of the bubble can also give nervous investors confidence to step into financial markets, with an understanding that backing away may be appropriate if the system begins to crack.

As always, this is something we would be delighted to chat about with you.

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