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