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Don’t ever say “bubble.”
As a finance professor, and researcher of so-called asset price bubbles, I have a certain attitude about the word. My attitude is that it’s the most over-used word in finance. Moreso even than synergies by the M&A crowd. In this article, I’m going to define a “bubble” from a financial economics (i.e. correct) point of view. Then I have a few things to say about recent burps in the stock market. sildenafil citrate tablets caverta 100
To begin, we define two values of an asset: the intrinsic value, and the market value. The intrinsic value of the asset is the present value of future cash flows, discounted at an appropriate rate. It’s what the asset would sell for if everyone had the same information and agreed about its implications. The market value is simply what the asset currently sells for, as determined by the laws of supply and demand. We (financial economists) say an asset is “fairly” valued when the estimated intrinsic value is close to the market value, and over- (under-) valued when the intrinsic value is below (above) the market value. Of course, we leave room for error, so “fair” can be in a big neighborhood around intrinsic value. buy viagra vancouver
In the context of equities, intrinsic value is the present value of future cash flows (e.g. dividends, or free cash flow to equity), discounted at a rate that reflects the risk-free rate of return plus a risk premium (called the equity risk premium). These cash flows, and the discount rate, are the fundamentals of the intrinsic value. The market value of a stock should reflect the intrinsic value. If it doesn’t, we can add a term called a “bubble.” It means that there’s something in the market value of the stock that is NOT generated by the fundamentals – it doesn’t belong. So, bubble.
Here’s the kick in the pants though – it is impossible – to identify a bubble. Even in retrospect. We can say “oh yes, stock prices were very high, relative to what the fundamentals actually became.” But stock price equations are all forward looking. And so identifying a bubble would require us to know ahead of time what the price should be (the intrinsic value), which means knowing the future realizations of the fundamentals, so that we can say “this price is not justified by future fundamentals.”
What we can do is discuss the likelihood that prices are currently close to or far from intrinsic value. There is absolutely no reason to pollute the discussion with bubble talk. And of course, Robert Shiller does plenty of work on this. His book “Irrational Exuberance” is all about it. Eugene Fama, John Cochrane, and others push back against him. It’s a rich field of research. But in the end, it still comes down to informed opinion, based on what we expect the future to be. If prices are really high, and the future fundamentals end up being great news, then those prices are justified. In not, then they weren’t. How can we say it was a bubble? It’s just that consensus opinion was off. viagra cheap
The take away is two-fold: (a) stop worrying about bubbles. You can’t know they are there anyway, and the “burst” is therefore unpredictable. And (b) manage your stock portfolio such that you don’t have to predict the downturn. See my article here.
By the way, if you are sympathetic to the Austrian theory of the business cycle, as I am, you might be thinking that ATBC offers guidance to predicting when ‘bubbles’ will ‘burst.’ I disagree. What it allows us to do is say that “conditions are good for the persistence of malinvestment, which will eventually unwind.” There is no timing guidance there. But, again, no theory of stock market crashes offers timing guidance that has been shown to be reliable in (a) predicting crashes and (b) not predicting false crashes. Cialis 10 mg
The Cranky Finance Prof Spouts Off
This is a mixed bag of economics, finance, and political philosophy.
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Martin Brock August 28, 2015 , 4:16 pm Vote2
Assuming as you do that markets are efficient, or that the market value of an investment is a Martingale process, and defining a “bubble” as any rise in this market value followed by a predictable fall, your conclusion follows. You conclude that bubbles don’t exist, but since the conclusion is only a logical consequence of your assumptions, it’s a logical tautology and thus not a very interesting.
I rather suppose that another definition of “bubble” is more consistent the usual usage of this word in a financial context. The precise timing of the popping of a bubble is unpredictable, but a bubble does not violate market efficiency, because market participants have a rational expectation of the rising price before the bubble bursts.
A rising price in the future is a rational expectation, but no particular end of the rise is rational, i.e. I can calculate the expected value of the price in the future, and the expected value as a function of time, given current information, increases monotonically, but I cannot calculate the time at which the price peaks.
The expected time of the maximum price given current information is not defined, i.e the integral defining this expectation does not converge, even though the integral defining the expected future price does converge and increases monotonically. If I can construct a process with these characteristics, then this process is a “bubble” consistent with common usage and does not violate market efficiency. I suggest the construction of this process as an exercise for your students.
Jeff Oxman August 29, 2015 , 11:33 pm Vote0
Martin,
I didn’t say bubbles don’t exist. My claim is that we can’t identify them. For example, at the time the tech boom was occurring, I claimed that prices had so significantly deviated from a justifiable level that they must be due to crash down. Turns out that I was right (and was able to lock in my profits about six months before the crash) but I could have been wrong if all the clicks had turned into sales.
The rest of your comment (paras. 2-4) is consistent with what are referred to as “rational bubbles.” I don’t think bubbles violate efficient markets. There is a very nice paper by Jose Scheinkman, I think 2006 or 2007, where he shows that a rational actor (he calls him the econometrician) that knows the price process might actually outbid other market players for a stock even though the econometrician knows (in the paper’s context) the market price contains a bubble. He does this because he expects to be able to sell the stock at an even higher price later, more often than not. I think the paper provides the model you are after.
Martin Brock September 5, 2015 , 4:15 am Vote0
I wouldn’t say that we can’t identify a bubble, only that we can’t predict when it will pop. When I blow a literal bubble, I don’t know precisely when it will pop, but I know it will pop. The bubble is a sphere, and if the surface of this sphere weakens sufficiently at only one point, a cascading effect leads to the disintegration of the entire sphere, but I can’t measure the strength of the sphere at every point across the entire surface. I can only know that a sufficient weakening at some point is inevitable in a time that I can’t predict precisely. Of course, “bubble” is only a metaphor for the market processes we’re discussing. Market bubbles don’t pop instantaneously as we imagine a literal bubble popping.
If Scheinkman’s econometrician can rationally expect to profit by outbidding other market players for a stock, then the market is not efficient. I think we can say now that a credit fueled bubble exists in corporate equity markets, but we can’t say that the current correction is the popping of this bubble, because we don’t know (and can’t know) precisely where the weakest link in the chain (to use a one dimensional metaphor) exists. We can only know that the system is fragile rather than anti-fragile.
Jeff Oxman September 5, 2015 , 10:36 am Vote0
Your first paragraph is a good reason to avoid using the word “bubble.” It’s just not a good metaphor.
And I’m sorry if you got the impression that Scheinkman’s econometrician is somehow making arbitrage profits. His position is risky, and there is a non-zero probability the econometrician will lose.
Finally, what evidence do we have that equities are priced abnormally high? Can’t they just be reflecting expectations of either high growth or low risk, or both?
Martin Brock September 5, 2015 , 9:45 pm Vote0
“Bubble” is only a metaphor. I don’t think it’s a bad one, but since metaphors aren’t mathematically precise, I suppose it’s a matter of personal preference. Everyone was talking about “systemic contagion” during the “financial crisis”, and this “contagion” sounds to me a lot like the cascading effect in the bursting bubble metaphor.
I only got the impression that the econometrician rationally expects a profit, not that his profit is certain. In other words, the mathematical expectation of his profit is positive, i.e. the sum of the product of profit and probability of profit in an exhaustive and exclusive set of outcomes is well-defined and positive. This sum can be positive even if a non-zero probability of loss exists. If the market is efficient, this expectation is zero (or the riskless rate of return); otherwise, investors bid up asset prices rise until it is. I think that’s the definition.
Market efficiency doesn’t imply that no one loses or that no one profits, only that current prices reflect rational expectations given available information. Here, “rational” means mathematically rational or ratio-able, i.e. the probabilities (which are ratios) are well defined and the sum (or integral) defining the expectation is well defined.
Evidence that prices are inflated by easy credit include leveraged buybacks for example. If corporations spend more than their earnings to buy their own stock, it’s hard to argue that they are investing in growth or that an expectation of growth explains the rising value of their shares. Corporate officers benefit from bidding up the price of their corporation’s stock this way through stock options, and this behavior can be perfectly rational from the officers’ perspective.
High prices can reflect expectations of high growth or low risk, but they need not. Many other possible explanations exist. Assuming that prices reflect these expectations can blind you to the other possibilities.
Jeff Oxman September 9, 2015 , 1:28 pm Vote0
Martin,
First, sorry for the long delay in replying. The semester started and there’s always a flurry of activity.
So, regarding the econometrician & expectation of profits – this really doesn’t have negative implications for market efficiency.
On buybacks: why would firms buy back their own stock if they are overvalued?
My point is that prices are driven by essentially three fundamentals. To say that the current prices reflect something other than action in those fundamentals requires the person making said assertion to prove it.
Martin Brock September 9, 2015 , 3:47 pm Vote0
“Firms buy their own stock” can be misleading. Individual decision makers within firms buy the stock using the firm’s earnings or credit. Buying the stock may disadvantage some shareholders, but these decision makers need not represent the interests of shareholders, any more than politicians or state employees necessarily represent the interests of voters or citizens more generally.
We have every reason to believe that something like public choice theory applies to corporate decision making and that something like regulatory capture occurs within corporations as much as it occurs within state bureaucracies. Many large corporations are little more than state agencies anyway. Corporate officers can and presumably to act to benefit themselves, not to benefit shareholders or “the firm” or a similar abstraction.
Again, the decision makers could benefit by selling stock options as prices rise, for example. Prices reaching an unsustainable level need not deter this practice.
I don’t accept the burden of disproving your theory that prices are driven by fundamentals; however, I do accept the burden of providing evidence in favor of one explanation for rising prices over another. If I provide evidence that companies spend more than their earnings to purchase their own shares even when other demand for the shares is weakening, would you agree that these purchases reflect (or could reflect) something other than the purchaser’s conviction that the shares are undervalued fundamentally?
If I expect a corporation’s share price to rise, I’ll buy shares and hold them until my expectation changes, but my expectation of a rising price need have nothing to do with an expectation of increased earnings or any other fundamental factor. I may only expect the price to rise because corporate officers have less costly credit with which to buy the shares or because I expect a bailout of an insolvent corporation or something similar.
If you include all of these factors in “fundamentals”, then I can agree that fundamentals determine prices, but these sorts of fundamentals need not determine stable prices and can raise prices to ultimately unsustainable levels, and this price elevation is what I call “a bubble”. I believe that markets are efficient, but the information determining the price of an asset need not involve an expectation of increased earnings from consumers or any other conventionally “fundamental” factor.
Martin Brock September 10, 2015 , 7:31 am Vote0
Correction: “… decision makers could benefit by exercising stock options as prices rise …”
I don’t mean to be arbitrarily adversarial here, Jeff. I appreciate an opportunity to discuss this question with a specialist as a mathematical abstraction. How the abstraction could be realized is also interesting, but we can discuss the possible realization of an abstract process after discussing the mathematical structure of the process. My academic background is in mathematics rather than finance, but I was always interested in applications to finance.
A decline in asset prices may not be predictable, but we need not assume that prices ordinarily reflect market fundamentals and explain price corrections in other terms only in hindsight. Popular media tends to focus on fundamentals while prices rise and then explain corrections in terms of extraordinary, external shocks, like contagion from the collapse of Chinese share prices, often in terms of irrational “panic” following these shocks. Why would price rises be rational while declines are irrational? Market efficiency doesn’t imply it.
Jeff Oxman September 10, 2015 , 9:03 am Vote0
Martin,
1. Buyback abuse: Yes, I think there is potential for this, just as there exist accounting shenanigans and the like to “pump and dump” the stock by insiders. But a big group of firms all doing buybacks belies something else, to my view. Right now, I think, firms are trying to lock in low interest rates on debt through leveraged recaps. Leveraged recaps generally involve raising debt to buy back equity and thus rebalance the firm’s capital structure towards debt, and lower the weighted average cost of capital (WACC). One of the persistent puzzles here is actually that American firms seem to have too low a long-term debt ratio (debt/market value of equity). This doesn’t have much to do with market efficiency, but it’s a puzzle and one maybe I’ll write up in a new post.
2. I think we’ve gotten a little far afield from my original point, which is simply this: while I can write down a model for stock prices that includes a non-fundamental component (we call this the bubble component), it is essentially impossible to empirically isolate that bubble component because all expectations are forward looking. Bubbles can also be negative, at least in the theory. And there is a lot of literature pointing out that bubbles can be rational (like the Scheinkman paper I mentioned). So the theory of bubbles doesn’t seem to contradict market efficiency because it’s based on expectations of things to come, not past or current public information. At the same time, I don’t think it’s helpful to empirically try to sort out bubbles because they aren’t identifiable in real time.
3. I wonder if some overreaction to negative news might be mitigated by allowing mutual funds to hold derivative products? Right now, a public, open-ended mutual fund can only sell to protect itself from downside, and that selling, if it were pervasive enough, could contribute to more price declines. Those price declines wouldn’t really be “news” though – what traders call “noise.” or liquidity moves (I gotta raise cash because people are exiting the fund!). However, if a fund could hold a few put options, the incentive to exit the stocks that are dropping would be mitigated. (Just thinking out loud, no empirical papers to back me up here).
4. I think stock prices might be sub-martingales, rather than pure martingales, because (in general) there is a higher chance of an “up” more rather than a “down” move. Does that sound correct? All my math finance books are at my office and I’m not going there today.
5. If you have the time, I highly recommend looking into the “Asset Pricing” course by John Cochrane, available for free at Coursera. I really enjoyed doing this course, as I haven’t really done math finance since my Ph.D. course work, almost ten years ago. If you dig math finance, it’s a great course. There’s also financial engineering courses on Coursera which are pretty fun.
3.
Martin Brock September 10, 2015 , 10:37 am Vote0
1. This strategy assumes that the corporation can sell its shares back to the public at the price it’s paying now on leverage; otherwise, it doesn’t raise enough to repay what it borrows now, so it doesn’t effectively borrow at the currently low interest rate. If prices start falling, a corporation may sell its shares to repay what it borrowed, hoping to avoid a further fall. This negative feedback could create downward pressure on prices in the way that margin calls create downward pressure.
4. Yes, as long as there’s a nominally riskless rate of return (like the yield of a Treasury security or other negotiable entitlement to tax revenue), I expect other returns to exceed this rate, so the expected future price of a growth stock (paying no dividend) is greater than the current price, and the series is a submartingale (assuming market efficiency) rather than a martingale. That’s my understanding anyway. Of course, as a libertarian, I oppose Treasury securities and the like.
Transaction costs also suggest a submartingale rather than a martingale, although a martingale or even a supermartingale is possible if investors expect asset prices generally to fall and holding cash is not an attractive alternative (because of inflation for example). In other words, the nominally riskless rate of return could be negative. Monetary authorities are deliberately engineering this possibility, of course. That’s what QE and interest bearing deposits at the Fed are about.
At some point, if you want the state to guarantee that you don’t lose money (by distributing tax revenue to you faster than inflation depreciates your currency), you’ll need to pay it for this security, rather than only expecting the state to pay you a smaller yield than you expect from riskier markets.