"The term bubble should indicate a price that no reasonable future outcome can justify.”
Fridays are the day I like to wax philosophical about all things market related, with an emphasis on the failings of your wetware. This week is no different.
The motivation for this week’s musings comes from the quote above, courtesy of Clifford Asness, quant analyst and founder of AQR Capital Management. In the Financial Analysts Journal, Asness published a list of his “Top 10 Peeves.”
I often find myself both intrigued by and in disagreement with Asness, on matters of economics, politics and central bankers. (See QE = Currency Debasement and Inflation.) However, in his list of peeves, I found myself in utter agreement on the question of whether or not current markets are in a bubble. Indeed, I especially found compelling his definition of how to define an equity bubble: “A price that no reasonable future outcome can justify.”
Now, before we proceed, allow me to share a few words about “Question Framing.” It is something every first-year law student learns. In the art of rhetoric, a properly framed question wins the debate before it even begins. Hence, if you accept a definition of a bubble as defined by Asness, the discussion is more or less already over. Such is the power of framing.
Regardless, I am hard-pressed to put forth a better definition.
Are markets bubbly? To be sure, we have seen frothy sentiment, and some specific holdings -- Tesla? Bitcoin? Netflix? -- surely look like trees that have grown to the sky. But having some equity issues that have gone completely ballistic is not the same as having an entire market become utterly unhinged from any reasonable fundamental moorings. Taken as a whole, can we (as defined by Asness) discover any "reasonable future outcome" that can justify present prices?
Based on this definition, it is difficult to conclude that markets are in a bubble. There are many “reasonable future outcomes” that would justify current prices. It would only take a small marginal improvement in the economy, or a small uptick in hiring, or heaven help us, even a modest increase in wages -- to increase revenues and drive profits significantly higher. What is currently a somewhat overvalued U.S. market could easily become a fairly valued or even cheap market if the economy were to accelerate modestly. That is without any help from Europe or Asia. If the worst in the EU zone is behind her, then it is quite possible that prices are very reasonable there and not ridiculous here. Note that this is not a forecast but merely an observation of a reasonable future outcome.
That is an admittedly big “if,” but I do not believe any fair-minded reader can say it is an impossibility. If we are honest, we must admit it is not the highest probability outcome -- which could explain why so many people have completely discounted it.
Analyzing prior bubbles via the Asness definition if not confirming it, at least does not eliminate its validity. The circa 2000 dot com/tech stocks boom easily fit this description. As Asness notes, there simply was no reasonable scenario that justified the P/E ratios of the Nasdaq back then (See "Is Nasdaq 4,000 for Real This Time?").
Reconsider, if you will, the subprime credit bubble and the huge spike in global home prices from 2001 to 2006. At that time, we saw the ratio between median home price versus median income in the U.S. move three standard deviations away from the long-term norm. Either that was a bubble due to collapse, or everyone’s salary in the U.S. was about to double. Clearly, that doubling was not a reasonable future outcome. (I still argue that the true bubble was in credit and not homes, but let’s save that discussion for another time).
Why all the bubble talk these days? Instead:
“We have dumbed the word down and now use it too much. An asset or a security is often declared to be in a bubble when it is more accurate to describe it as ‘expensive’ or possessing a ‘lower than normal expected return.’ The descriptions ‘lower than normal expected return’ and ‘bubble’ are not the same thing.”
Indeed, I again find myself in utter agreement with Asness. My explanation for this is simply an example of the Recency effect. The memories of the past bubbles, where asset classes utterly collapsed, are still too fresh. The Nasdaq fell about 80 percent from its peak to trough. Look at the Home Builders, the Money Center Banks, the Brokers/Investment Firms: From their highs to their lows, these sectors also crashed about 80 percent. If you measure the losses of many home buyers, they ended up losing all of their invested capital (i.e., what little down payments they made).
If we rely on the definition of a bubble that Asness has provided, we reach the conclusion that we are not in an equity bubble. But rather than rely on a definition that reaches that conclusion, let’s give you, dear reader, the opportunity to reframe the question yourself:
How would you define a bubble? And based on that definition, are we in one now?
I am curious as to what the astute readers of Bloomberg View have to say . . .