Bubbles and Nobel Prizes
Board: Real Estate Investment Trusts
Given the scarcity of posts over the past week, I am taking the liberty of copying and pasting a blog post that I did for SNL a few weeks ago.
Last week a friend of mine sent me an interesting blog post appearing in the Financial Times. A couple of weeks ago the Nobel Prize was awarded to three academic economists, at least two of which – Eugene Fama and Robert Shiller – have done some excellent work pondering the rationality of market trends and prices. Ironically, Messrs. Fama and Shiller have quite different opinions.
An issue in which investors are always interested is whether market prices are efficient and rational. And, given today’s very low bond yields and extraordinary performance by the equities markets this year (the S&P 500 and Russell 2000 indices were up 23.4% and 31.7%, respectively, as of October 25), not to mention recollections of the collapse in home prices over the past several years, it’s not surprising that “bubble” is a word that’s used far more often in the investment world today than in judging panels for Champagne.
The above-mentioned Financial Times blog post points out that Mr. Fama has always been skeptical that investment bubbles can even exist; high asset prices cause reduced risk appetites in response to lower expected future returns, in turn causing prices to rationally decline, and vice-versa. The post also notes that Mr. Shiller disagrees – claiming that “it is implausible that risk appetites in financial markets change in a manner which can explain” market over-reactions to “economic fundamentals,” and thus behavioral factors can affect asset prices. Academic economist John Cochrane, according to the Financial Times blog post, believes that “empirical work has so far failed to determine conclusively whether Fama or Shiller is right.”
I am, of course, no academic, and Riley and Kacie (my Golden Retrievers) have a greater chance of winning the Nobel Prize than I do. However, I have observed markets – and played in them – for almost 50 years, and have read about them extensively. And I can claim confidently that, although they don’t arise very often, investment bubbles do exist.
Investing isn’t science; determining investment values requires the application of numerous macro and micro assumptions, and these assumptions are often influenced by the investor’s state of mind. And these states of mind are often affected by wishful thinking, the oft-felt need to be in sync with fellow investors, the fear of missing a great party (or of losing performance-oriented clients), the natural belief that existing trends will continue as they have, and lots of other less-than-entirely-rational thoughts. And, as far as I know, humans are still somewhat influenced by the reptilian portion of the brain, which engenders both fear and greed – and this can often influence investment behavior. Fear? Remember the fall of ’08 and the spring of ’09, when the RMZ traded at just over 300? Greed? Were you around when Henry Blodgett and Mary Meeker were doing their thing?
Former Fed Chairman Alan Greenspan recently wrote a book, “The Map and the Territory.” It was reviewed in last Tuesday’s Wall Street Journal by Burton Malkiel. The reviewer notes, “Forecasting can be improved, he [Greenspan] says, if specific behavioral conditions and tendencies – such as euphoria, fear, panic, optimism and herding – can be incorporated into forecasting models, including the irrational ways in which people behave in times of stress.”
It is certainly true that there are many intelligent, rational and flinty-eyed investors out there, who sell when prices are high and buy when they are low. This, as well as the almost-instantaneous dissemination of market-moving information, provides for efficient market prices most of the time. That said, Charles Mackay reminded us, as far back as 1841, of the madness of crowds, and students of the Great Tulip Bulb Craze in the 1600s and similar events of market craziness that occurred many times thereafter know that the behavior of investors can occasionally become outright bizarre.
But identifying bubbles as they occur isn’t easy. High prices alone, of course, do not signify bubbles; such prices may merely discount improving future cash flows or economic prospects that many investors simply don’t yet recognize. Mr. Market is usually a pretty smart guy. As Mr. Greenspan himself famously noted, bubbles are, too often, recognized only with hindsight – not many investors shorted houses or residential mortgages in 2007, and Chairman Ben himself (no dummy) professed no worries regarding the housing market in 2006-2007.
And yet, it’s my belief that we can, at times, spot bubbles as they become really large; many did so when dot.com stocks were running amok in the late 1980s and into early 1990 (guessing the actual peak, of course, is much more difficult). I also believe that we will have a better chance of identifying an investment bubble in real time if we look at several factors that may be present concurrently. These might include, in addition to high prices relative to prior norms, the following: Instant billionaire success stories, massive cash deployment into the asset class by uninformed “investors” such as jockeys and shoe-shine boys, a major deterioration of underwriting standards by lenders (using other peoples’ money or otherwise having no skin in the game), and value justifications using “new paradigms.”
So, are we presently witnessing any such bubbles in the stock market, real estate market or bond market? Probably not. Prices may be a bit higher than may be warranted by historical yardsticks; perhaps, by driving investors into risk assets, the Fed’s QE activities are somewhat responsible for that. But prices are logically linked to returns on risk-free assets, such as US Treasury bills or notes (although how long these remain risk-free is anyone’s guess), and interest rates are properly low when economic growth is an almost-endangered species. Last Tuesday’s employment report didn’t exactly knock our socks off. And, while I certainly acknowledge the risk that today’s prices will later be deemed “too high” if interest rates and bond yields rise significantly next year, I am not seeing any of the bubble factors suggested above.
If prices for stocks, real estate and/or bonds on October 28 are later proven significantly higher than they “should be,” it will be because we are failing to anticipate some unexpected negative macro event – and not because of bubble pricing. The most likely negative scenario, should it transpire, is that future returns will be something less than we’ve enjoyed historically due to risk premiums (and, perhaps, the risk-free rate of return) increasing. Accordingly, it’s difficult for me to conclude that today’s markets aren’t fairly efficient. As a result, I am neither bull nor bear. Perhaps I am merely a chicken.