Bubble Detectives

“One important conclusion is that the probability that the S&P 500 index is currently in a bubble is only 20-33 per cent,” according to Gavyn Davies in his recent article for the Financial Times, “How to detect amarket bubble.” “But that could change fairly quickly during 2014 if the recent pace of advance in equity prices continues.”

Davies approves of the New Palgrave definition of a financial bubble:

Bubbles are typically associated with dramatic asset price increases followed by a collapse. Bubbles arise if the price exceeds the asset’s fundamental value. This can occur if investors hold the asset because they believe that they can sell it at a higher price to some other investor even though the asset’s price exceeds its fundamental value.

Davies then mentions two other bubble detectors:

Based on the Shiller cyclically adjusted p/e (CAPE), the probability of a bubble is estimated at 33 per cent in December 2013, while the price/dividend model produces a bubble probability of 20 per cent.

These three bubble detectors have one thing in common. They begin with the standard assumption that the net present value (NPV) of future dividends or earnings equals the fundamental value. Then if the NPV is lower than the current price, they say the market, or an individual stock, is “overvalued.” 

As I have written before, NPV is not an objective measure of value because it requires 1) forecasting sales and 2) choosing a discount rate, both of which are highly subjective steps. 

Davies refers to a paper on a new econometric technique for detecting bubbles. The authors of the paper write that although equity prices have rising 40% in the past couple of years, that doesn’t indicate the market is in a bubble because dividends rose 34% over the same period. When adjusted for the “fundamentals,” that is, the dividends paid in the past, “there has not been explosive growth in equity prices...”

However, the authors recognize a weakness in their method: 

... a high price-to-earnings ratio may reflect over-optimistic views about future earnings growth because investors may expect the recent increase in the profit share in the economy to persist. Prices, then, can still experience significant corrections if these optimistic forecasts fail to materialise and the profit share reverts to its past historical average. The fact that we do not detect a bubble does not therefore mean that there is no risk of low returns going forward.

And that is the reason many investors will lose a lot of money in the next collapse of the stock market. The authors should place more emphasis on estimates of future earnings and less on the psychological aspect in which investors believe they can find a greater fool. The greater fool theory has some validity, but in reality it is nothing more than investors doing linear forecasting instead of thinking cyclically. 

The major collapses in the stock market happen when investors realize their forecasts of future earnings were way off the mark. When do they realize that? The notion hits them like a cold ocean wave breaking over their heads when a recession hits and profits plummet. 

From an Austrian economics perspective, the market is always in a bubble during an expansion because the Fed is pumping new money into the economy like a fireman. Of course, the Fed members think of themselves as financial firemen. So the ratio of the increase in prices to dividends means little because Fed credit expansion inflates both at the same time. 

The market will be in a bubble if the economy is in a bubble and it always is in a bubble except during recessions because the Fed is always inflating the bubble with massive amounts of new money creation. Price-earnings (PE) ratios can remain flat even though profits are rising explosively and the economy is raging if prices keep up. PE will grow only if investors are willing to take more risk for the same profits. In other words, if risk tolerance expands. 

Bubble detectives are watching the wrong set of suspects. They should follow the Fed and the business cycle that its monetary policy creates. But that would require recognizing that mainstream business cycle theory, which is little more than “@#$%^ happens,” is wrong. Successful investors will have learned the Austrian Business Cycle Theory.