Can you spot a bubble?

The word “bubble” gets bandied about a lot in investing. Yet there’s no real agreement on what it means. John Stepek looks at how to spot one before it pops.

The word "bubble" gets bandied about a lot in investing. Yet there's no real agreement on what it means. Fans of the efficient-markets hypothesis (the idea that all information is reflected in asset prices accurately and in a timely manner by rational buyers and sellers) question whether bubbles even exist. That might sound like academic pigheadedness, given the dotcom boom and the subprime bust. Yet they have a point. Bubbles tend to be widely identified only once they have burst (or they wouldn't become bubbles in the first place).

So can you spot a bubble before it pops? A recent paper by Robin Greenwood, Andrei Shleifer and Yang You of Harvard University suggests you can. The team analysed boom-and-bust cycles in US industries between 1926 and 2014, and internationally from 1985 to 2014. They concluded that not all booms (defined as a doubling of an industry's share prices within two years) end in busts (a 40% drop in prices from peak to trough inside two years). "Many industries that have gone up in price a lot just keep going up" or don't fall sharply enough to justify being described as a "crash". However, those that do share certain traits. So what should you look out for?

Firstly, the more violent the price rise, the greater the odds of a crash. Overall, the researchers identified 40 booms using their criteria (which shows how rare these things are). If prices had doubled in the two-year threshold, there was a 53% chance of a crash. But if prices had risen by 150%, the odds rose to 80%. Increased share issuance is also a red flag (companies selling new shares, or new companies stampeding to go public). A third warning sign is the share prices of companies in "new" industries greatly outperforming those in old ones.

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In short, all the usual signs of "irrational exuberance". Yet it's still hard "to bet against the bubble". You'll usually be too early. "Of the 21 episodes in which a crash does occur on average prices peak six months after we first identify the industry as a potential bubble candidate." During that time, prices rose another 30% on average. Yet the rewards are worth it dodging crashes can add 10% to long-term returns compared with a "buy-and-hold" strategy.

So what does their work suggest about today's markets? Not a lot as Lu Wang reports on Bloomberg, "nothing going on in the market today would've qualified for investigation under the authors' base case for bubbles". That doesn't mean you should pile in the US market in particular looks expensive, implying mediocre long-term returns. But correcting that overvaluation may involve a protracted period of poor returns, rather than a short, sharp bust.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.