Stock market bubbles under the microscope

My thanks to Tim du Toit, founder of EuroshareLab, an excellent Europe-wide stock screening service, for alerting me to this interesting and sensible academic perspective on stock market bubbles – how to measure them, what to think about them, how to react to them.  The author is Aswath Damodoran, a professor at the Stern School of Business at New York University.  His article includes a number of spreadsheets which readers can usefully adapt to make their own calculations of PE ratios and future returns.

Here are his conclusions:

  1. There will always be bubbles: Disagreeing with Gene Fama, I believe that bubbles are part and parcel of financial markets, because investors are human.  More data and computerized trading will not make bubbles a thing of the past because data is just as often an instrument for our behavioral foibles as it is an antidote to them and computer algorithms are created by human programmers.
  2. But bubbles  are not as common as we think they are: Parting ways with Robert Shiller, I would propose that bubbles occur infrequently and that they are not always irrational. Most market corrections are rational adjustments to real world shifts and not bubbles bursting and even the most egregious bubbles have rational cores.
  3. Bubbles are more clearly visible in the rear view mirror: While bubbles always look obvious in hindsight, it is far less obvious when you are in the midst of a bubble. 
  4. Bubbles are not all bad: Bubbles do create damage but they do create change, often for the better. I do know that the much maligned dot-com bubble changed the way we live and do business. In fact,  I agree with David Landes, an economic historian, when he asserts that  “in this world, the optimists have it, not because they are always right, but because they are positive. Even when wrong, they are positive, and that is the way of achievement, correction, improvement, and success. Educated, eyes-open optimism pays; pessimism can only offer the empty consolation of being right.” In market terms, I would rather have a market that is dominated by irrationally exuberant investors than one where prices are set by actuaries. Thus, while I would not invest in Tesla, Twitter or Uber at their existing prices, I am grateful that companies like these exist.
  5. Doing nothing is often the best response to a bubble: The most rational response to a bubble is to often not change the way you invest. If you believe, as I do, that it is difficult to diagnose when you are in a bubble and if you are in one, to figure when and how it will dissipate, the most sensible response to the fear of a bubble is to not change your asset allocation or investment philosophy. Conversely, if you feel certain about both the existence of a bubble and how it will burst, you may want to see if your certitude is warranted given your metric.

My view: there is no doubt that the word “bubble” is much over-used and a cover for lots of sloppy or wishful thinking. It obviously makes sense, for example, to adjust PE calculations for the level of interest rates. It is also true that any form of PE ratio remains a poor guide to short term market behaviour, but once adjusted can be reliably used as a measure of the risk of loss over time. Although that risk is clearly rising, the most important point Prof Damodoran makes, in my view, is that you still need a very high conviction that stocks are overvalued before it makes sense to take decisive avoiding action. That time is edging ever closer, but my sense is we are not quite there – yet. Nevertheless future returns from new money invested at these market levels is likely to be below long run averages.