What is a Bubble?

“The term bubble should indicate a price that no reasonable future outcome can justify.” – Cliff Asness

There’s been a steady stream of bubble talk since the financial crisis. Everything that goes up in value ends up being called a bubble — stocks, bonds, gold, IPOs, biotech, Silicon Valley, etc.

Most investors seem surprised more than anything by the magnitude of the rise in risk assets. Nearly everything went down in value during the crash, but now everything has recovered and many have been caught off guard in both directions.

These days anything with a sustained gain is called a bubble that’s just about to burst. But what is a bubble? Robert Shiller had this to say in his book Irrational Exuberance:

I define a speculative bubble as a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a larger and larger class of investors, who, despite doubts about the real value of an investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.

Because Shiller successfully warned of the excesses before the tech and real estate bubbles, his CAPE valuation method is often used by pundits and investors alike to signal froth in the markets. The problem is that so many people trot out predictions based on this methodology with 100% certainty. Shiller has a more realistic interpretation:

Those who predict avalanches look at snowfall patterns and temperature patterns over long periods of time before an actual avalanche event, even though they know that there may be no sudden change in these patterns at the time of an avalanche. It may never be possible to say why an actual avalanche occurred at the precise moment that it did. It is the same with the stock market and other speculative markets.

Many point out the fact that we’ve only seen CAPE valuations on the S&P 500 at or above current levels three times since the late 1800s — 1929, 2000 and 2007. There is a growing chorus of industry watchers that point to these values as a sure sign we’re at another peak in the market.

The flip side of that argument is that it’s only happened three times. That’s an extremely small sample size. It’s a scary sample size, but a small one nonetheless.

Things don’t have to happen in the markets simply because that’s what happened in the past. Financial markets tend to make people look silly when they have 100% certainty one way or another.

If no one knows either way what’s going to happen then what’s an investor to do these days?

Shiller recently sat down for an interview with the UK-based financial website This is Money and offered this answer that I wholeheartedly agree with:

What should an ordinary investor do with their money in these kind of markets?

‘If I was counselling an individual and my purpose was to help that individual, the most important thing would be that you should save more,’ says Shiller. ‘Because don’t expect that your retirement will follow those trajectories that some advisers are telling you.’

It’s not a top call or a trading tactic you can implement right now to hedge out your portfolio, but saving more money is still one of the best ways to reduce your risk in the markets.

Bubble or no bubble, saving more money provides a margin of safety against the possibility of lower market returns in the future.

Sources:
Irrational Exuberance
‘We saw this before the Wall St crash, the dot-com bubble and the credit crunch’ – How Nobel economist Robert Shiller’s CAPE warning light is flashing again (This is Money)