“The term bubble should indicate a price that no reasonable future outcome can justify.”

-Clifford Asness



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 . . .


Originally published at Bloomberg View


Category: Investing, Psychology

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

23 Responses to “How Do You Define a Bubble? (And are we in one now?)”

  1. dctodd27 says:

    Does it even matter at this point? Asness’ own research on CAPE (see: An Old Friend: The Stock Market’s Shiller P/E) shows we are now in the bottom decile of starting P/Es (25+), which historically have averaged a subsequent annualized 10 year return of 0.5%. GMO is calling for -1% real on large caps and -4% real on small caps over the next 7 years. Hussman is expecting the same. These guys have all been correct in their broad market forecasts over the years.

    Is it *possible* that things work out better than expected? Sure, but prudent investing doesn’t rely on best-case scenarios. In fact, that’s the exact opposite of the concept of insisting on a margin of safety.

    So….my questions have been and will continue to be: 1) How much worse do expected returns need to get before everyone is in agreement that it *is* a bubble? 2) Does it even matter?

    • That is exactly why he states “lower than normal expected return’ and ‘bubble’ are not the same:

      “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.”

    • rd says:

      I think there is a big difference between owning the NASDAQ in 2000 and the S&P 500 today. A -1% real return forecast for the S&P 500 over the next 7 years is not much different than holding cash at 0% with the Fed saying they don’t intend to raise the Fed Funds rate for a couple of more years, potentially longer. However, seeing your investmnet drop 80% and only coming back close to the original price when iti s over-valued so it could probably lose a bunch of it again was a bubble.

      Similar to Barry’s comment on the hosuing bubble actually being a credit bubble, in 1929 the stock market was over-valued but the real bubble was non-DJIA speculative stocks and margin debt where a lot of people only had 10 cents on the dollar equity and so the slightest drop in the market would wipe them out. BY 1932, the DJIA was yielding 8%-10% dividends which showed how under-valued it was then unlike the paltry dividend yields in the NASDAQ in 2003.

      There is also a difference between investment bubbles that provide hard tangible things for the economy versus financial bubbles that simply consume money and savings. The railroad bubble left thousands of miles of track behind that we have been using for 150 years. The dot.com bubble left behind lots of infrastrcuture (fiber optic cable etc.) that has allowed the explosive growth of the Internet, and the hosuing finance bubble will have left us behind an excess stock of housing that can be used over the next couple of decades. Bubbles with major financial components, like 1929 and 2008 leave behind misery and unemployment.

      We can have reverse bubbles of pessimism too. 1932 and 1982 come to mind where we saw explosive growth over the next two to three decades after those bottoms. The 1932 was a massive bottom for the stock market and the 1982 was a massive bottom for both the stock and bond market.

      I don’t think we have had our massive bottom of pessimism yet. There is still a bubble of hope that the Fed and other Central Bankers will magically make all of our economic problems go away by buying lots of government bonds. I think it is a useful tool to buy time to allow the problem to get fixed, but it is not the fix. So we will see if the bubble of hope crashes or not.

  2. b_thunder says:

    Either the 10yr treasury 1.5% yield earlier this year was “a price that no reasonable future outcome can justify”, or we’ll be in a near zero growth/zero inflation or deflationary environment for a number of years (i.e. japan 2.0)
    And if it is the latter (near zero growth environment) then the equities are very overpriced in general and compared to Nikkei 5 years after that bubble peaked.

    • I like your line of reasoning. I might phrase it like this:

      Treasury and other bond yields remain near all-time lows, covenant-lite debt issuance is soaring, and total credit in the system is at historically very high levels. Are bonds at “a price that no reasonable future outcome can justify” i.e. in a bubble?

      On the one hand, if the bond market is in a bubble, then other markets will be bubbly as well, because low interest rates cause repricing throughout the whole system. The normalization of the bond market bubble (rising interest rates) will also have strong effects on the valuations of the other markets.

      On the other hand, if the 10 year isn’t in a bubble now, and 1.5-2% yields are reasonable, then growth and inflation will be low for years to come, and stocks are heavily overpriced for that environment.

    • rd says:

      Actually, from 1952-1959 the 10-yr T-bond ranged between 2.3% to 4.0%.That was a period of very good growth in the economy and the stock market. We are in that range today. It didn’t go above 5% until 1966. The US also had a very high debt load in 1946 after the war, so low interest rates were possible just a few years after that.

      I think we are very biased today about interest rates because they have been unusually high since the late 1970s until just a few years ago. The level of interest rates that dominated throughout the 50s has only become returned to consistently since 2007 While 1.5% was low by historical standards, the general long-bond interest rate environment of the past 6 years has been quite common in the past. I haven’t seen long-bond speculators collapsing because the 10-yr went from 1.5 to 2.6, so it doesn’t appear to be as unstable as over-valued stock markets with high margin debt.

      ZIRP for short-term interest rates is very, very low and generally unprecedented but nobody really invests in cash.


  3. Zedpher says:

    I created an analytical method for detecting bubbles in markets. I have a post over at Seeking Alpha http://m.seekingalpha.com/instablog/3263651-zedpher/2466261-stock-market-bubbles-past-present … am not trying to spam here. Just that I have found that my system shows stocks usually peak in the same range during periods where the consensus is that prices are out of hand. You can see examples in that article. Right now, I only see bubbly action in the NASDAQ, Russell, and the Nikkei. If anyone finds this spammy, I sincerely apologize as I have been following Barry and his writings for many years now. – Frank

  4. supercorm says:

    If the Fed sees the GDP growth (nominal) at 4.0% in 2015, I don’t know why we still have 30yr bonds below 4.0% … 30 years, pricing less than what the short term predict, every year!

  5. BuildingCom says:

    We’re still in a massive housing bubble and now it’s global.

  6. Molesworth says:

    How are you defining “massive housing bubble” and why do you think it’s global?

    BR 2 part question was:
    How would you define a bubble? And based on that definition, are we in one now?

    You didn’t answer the first part.

  7. Nojo says:

    As a psychologist, to me any definition of «bubble» would have to have the word hysteria in it.

    We are definetively not there.

    • BuildingCom says:

      Some measures to use to determine a bubble:

      -Is there dumb borrowed money? (Housing is a resounding yes)

      -Did you look at the price?(Regarding housing, most will say they didn’t look at the price)

      -Are you howmuchamonth-ing it?(Housing is a resounding yes)

      -Is the sentiment a “can’t lose” proposition? (Housing sentiment right now is just that)

      I could go on.

  8. ch says:


    The fed is printing $4B a day out of thin air and using it to distort the price of the fundamental price of all economic activity, Treasury bonds, for purely political reasons.

    The bubble is in the # of people that are still using the dollar to determine the value of other goods – they are akin to those that believed the sun revolved around the earth. In the same way, those people see the price of everything in the world rising and debate whether it is bullish or a bubble when they don’t realize that it is instead the early signs of the dying of their money.

    “When things get really bad the price of everything goes up.”

    • Yes, the Fed is distorting prices. Almost everything else you wrote is shite:

      1) No, the Fed is not printing $4B a day out of thin air;
      2) No, it is not for purely political reasons;
      3) No, the dollar isn’t a bubble;
      4) No, the price of everything isn’t going up.

      Please send me all of your fiat currency for proper disposal

      • BuildingCom says:

        #4) Well…. you’re sort of right on that one Barry. The price of *everything* is already massively inflated.

  9. ch says:


    1. $85B/mth of QE, over average of 22 biz days/mth = just short of $4B/day. If it’s not out of thin air, where does the Fed get the money to conduct QE from?

    2. If you disagree that QE is politically-driven, I would be interested in your take as to why you think they are conducting it?

    3. The dollar was made the reserve currency based on a set of trade & economic circumstances that no longer even come close to existing. The dollar still gets a halo effect from those historical circumstances that used to exist when in fact US finances are just as bad or worse than several European nations who have already effectively defaulted on their debt (the PIIGS)…

    4. You’re right, the price of everything isn’t going up…gold prices are collapsing as the gold derivative market is being imploded by an unprecedented run on physical supplies (run on collateral in a highly-levered market) that are leading to a collateral shortage in that market & therefore a collapse in gold derivative prices…ironically, the collapse in gold prices driven by an unprecedented run on physical gold is another symptom of a dollar bubble – Chinese Treasury bond holdings unchanged last 2 yrs…Chinese gold holdings up 2,000+ tons last 2 yrs…

    RE: Sending you my fiat for proper disposal? That’s exactly what the US’s biggest creditor (China) has been doing – swapping USD for hard assets (oil fields, ore mines, gold, ag production, ghost cities, etc.) as fast as they can…another sign of a bubble – US banks are happy to hold dollars…China would rather have ghost cities than excess dollars…

    Short term, the US banks are probably right…long term, China has a demonstrated 80-90% loss of USD purchasing power in oil terms in just the past 10 years (oil from $20 to $110) to point to & a US entitlement obligation ($120T) that makes QE cessation unlikely…

  10. ch says:

    I’d just add that ironically, the fact is that if I’m right, that there is a dollar bubble, it is very bullish for stocks…& with a Fed artificially capping long rates, IMO the right way to play it is “levered-beta.”

    Borrow money & buy US equities (& artwork, & real estate, & housing, & farmland, & jewelry, & classic cars), regardless of fundamentals, seems to be the right play in the case of a dollar bubble…in other words, effectively exactly what has transpired since fall 2011…