Asset Bubbles Don't Need an Event To Burst: They Just Burst

A common question I get revolves around when stock prices are going to fall or rise. “Should I be buying stocks now?” or “Are stocks in a bubble and if so when is it going to burst?”

Asset bubbles don't necessarily need an "event" to pop. Asset bubbles can just pop for no identified reason and at any time.

Asset bubbles don't necessarily need an "event" to pop. Asset bubbles can just pop for no identified reason and at any time.

Conventional wisdom says we need to find some kind of catalyst or crystalizing moment to occur. Things happen for a reason. Recently in economic circles, that watershed moment has been identified as when interest rates going up. Many analysts have said the moment Central Banks like the Federal Reserve in the US start normalizing interest rates from near zero percent that that will cause stock prices to plummet.

In Richard Thaler’s book, Misbehaving: The making of behaviorial economics, Thaler cites a couple of research papers from Robert Shiller, which created a firestorm in financial academia. The first was  “Do Stock Prices Move Too Much to Be Justified by Frequent Changes in Dividends?” Shiller claims that stock prices behave very irrationally compared to dividends which are more stable over long periods of time. If you believed in the Efficient Market Hypothesis, Shiller’s paper was downright blasphemy.

In Shiller’s other paper, “Stock Prices and Social Dynamics” he observed that social phenomena might influence stock prices just as much as they do fashion trends. Hemlines go up and down without any reason. He argued that stocks behave in the same way. His observations were quite similar to Keynes “animal spirits” analogy. Again more outrage by the financial wonks.

Shiller’s papers feed into the concept that looking for that black or white, in your face, crystalizing capitulation moment that will positively or negatively impact stock prices is extremely difficult if not impossible if history is any indication.

Thaler cites the 1987 stock market crash as an example. Monday Oct 19, 1987 was day without any important news, financial or otherwise. No war started, no political leader was assassinated, and nothing else of note occurred. The Dow Jones closed down over 20 percent on the day. Other global stock markets also had a terrible day. It just happened.

The gist of Shiller’s papers is that during these particular watershed moments, prices reach an inflexion point of variability. If prices are too variable, then they are in some sense wrong and thus it is very likely a moment of under or overreaction by investors.

When you look at the physical act of blowing a bubble, some grow very big and some grow very small. Some burst right away, some float for long periods and then burst. It’s very random. Sure there are some variables like wind, contact with an object that can cause bubbles to burst, but there is no guarantee that these variables will exactly predict when the bubble will pop. The discipline of behavioral finance believes that stock markets behave in a similar way. With so much information being processed about prices, trade volumes, earnings reports, analyst recommendations the conventional wisdom is that these variables will drive price volatility. Shiller and Thaler’s observations offer a different perspective that stock markets correct very randomly. A lot of people get paid a lot of money to predict when these bubbles will burst, but reality it is pretty impossible to do it once or even consistenly. Stock bubble’s burst when they want to burst and on their own schedule. The best you can do is evaluate conditions to determine if there is excessive investor sentiment and price euphoria for assets and position your portfolios to adapt to the eventual volatility, good and bad.