Odd Lots - This Is How You Know When the Stock Market Is in a Bubble

Episode Date: March 31, 2017

One of the most fascinating market phenomenons is the bubble. When they occur, fortunes are made and lost, and the full spectrum of human emotions, from fear to greed, are on display. But what defines a bubble exactly, and how do you know when you're actually seeing one? This week on Odd Lots, we speak with Harvard Business School economist Robin Greenwood, who has figured out the key characteristics that all stock market bubbles have in common.See omnystudio.com/listener for privacy information.

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That's vanguard.com slash audio. All investing is subject to risk vanguard marketing corporation distributor. Put knowledge to work and grow your business with CIT. From transportation to health care to to manufacturing, CIT offers commercial lending, leasing, and treasury management services for small and middle market businesses. Learn more at CIT.com. Put knowledge to work. Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Wisenthal. And I'm Tracy Allaway. So Tracy, I have to admit, I have a certain pet peeve about other financial journalists. Just one? Just one, Joe.

Actually, a lot. Haven't you been complaining that I've been attacking financial media too much at work and stuff like that? Well, good, because now I have an entire setup to an episode that's basically me just venting about other people in our field. This is exactly what I wanted. No, you know it really annoys me? The prevalence of people to say that there's a bubble and everything. Journalists are always calling things a bubble. If you go back to any market at any time, you could probably find someone who is like stroking their chin and trying to sound smarter and more wise than everyone else and saying, oh, this is a bubble.

It looks like to me because they want to be the wise, skeptical one that didn't get caught up in the hype. Right. Okay. I mean, I get the complaint. But isn't that sort of like our goal in life is to be the watchdogs with the potential like disaster? scenario always ready at hand? Shouldn't we be warning people? We should be, I think we should be judiciously warning people, but I mean, the goal should be right, to be right, not necessarily. And there are other ways to express concerns about development rather than calling something a bubble

immediately say bubble. Okay, I'm with you that the term bubble might be overused, yes. That being said, it's kind of timely now because, you know, just talking about the stock market. The stock market is at highest level or very close to its all-time highest levels. Many traditional valuation measures are arguably stretched. And there was a survey recently done that showed Americans are more bullish about the stock market than they have been at any time since the tech bubble. Right. Americans and also their fund managers, right?

Everyone seems to be super optimistic at the moment. Exactly. At least about equities. Yeah, at least about stocks. And, you know, there's that, just that alone would be a cause for some reason to perhaps be concerned. But then, you know, you sort of layer on top of that, the sort of a volatile political environment. And you certainly have a lot of people right now who are starting to throw around the B word again with regards to stocks. The B word.

But, I mean, when you hear a statistic like people are the most positive on stocks since the year 2000, you immediately remember. what happened in the year 2000 or shortly thereafter, right? No, you have to immediately say, well, that might be a bad contrarian signal. But rather than just speculate and rather than just throw out random statistics and say, ooh, scary, the last time this happened, markets plunged right afterwards, how about we actually talk to someone whose expertise is in identifying when the market is in a bubble or not? You sure you don't just want to like stroke your chin and pontificate? We could do that a few more minutes and I can just rant some more. But I don't know.

Maybe we should actually talk to someone who knows what they're talking about. Okay, let's do it. Who is it? So today we are going to be talking to Robin Greenwood. He is a professor at Harvard Business School. And as part of his research, he looks into what are the true characteristics of stock price bubbles. What do they have in common? How do you distinguish between what is a bubble and what's just a rock?

rising boom. He sounds perfect. Let's bring him on. He is perfect. Robin Greenwood, thank you very much for joining us. Hi, Joe. Hi, Tracy. So let's just start with a question. Why is it so hard to call bubble? People, as we were just talking about, people do it all the time. Sometimes it seems really obvious that something must be in some irrational price. Actually, you know what? Here's the question. Now, yeah, why is it what's so? Okay, here's my question. What is a bubble? People throw this a word around and Tracy and I probably mentioned it 15 times in the intro, but what is a bubble? So it's funny that you were talking about journalists and how regularly they're willing to use the word bubble. Among economists, bubble is actually somewhat of a four-letter word. I mean, I can't tell you the number of times that I've been in conversations with other economists and describe something as a potential bubble.

and they say, what do you mean what's a bubble? It's a bubble. There's no such thing as a bubble. And in fact, that idea is pretty well encapsulated by one of the most recent Nobel Prize winners, Gene Fama, who has famously said in lots of different outlets that there's really no such thing as a bubble. And I think that the starting point for many economists is that it's easy to say after the fact that something has crashed or that something has run up and that. then the crash. But in fact, it's not really very meaningful to describe something after the fact. You really want to be able to say something, as you point out, before the fact, before the crash. And so I think people have in mind lots of different concepts when they talk about bubble. We actually defined in our work, we made a very specific decision to have a narrow concept of a bubble, which is a very rapid price run up followed by a crash. So really, think 19. 1999.com stocks. That was our idea. Let's try to understand episodes that are like that. So someone in the investment industry once told me that another term for a bubble that hasn't

crashed is a really good bull run, right? So when you look at your definition of bubbles, How many actual bubbles do you count versus how many really good bull runs that haven't ended with a crash? Great. Yeah. So we looked in history. And we looked at industries. And the reason we looked at industries was because in many of these runups like dot com and in the 1920s, there's this huge industry component. So, for example, not every industry went up in the late 1990s. So that said, looking at these 100% price runups, we only find 40 since. the 1920s in the U.S., and roughly half of those crash. And then we also look at 34 countries back to the 1980s, and we identified 107 episodes and essentially find identical findings there, which is to say that about half of those crash as well.

Now, one of the challenges and one of the reasons this is such an important and difficult question, and I want to next get to the sort of common character. characteristics of all these bubbles. But one of the reasons why it's such a important question is that calling a bubble is a very difficult thing for investors and can often be harmful to one's career, even if correct. So one might have identified in 1998 or 1999 that internet stocks were in a bubble, but you might have gone broke between 1999 and March of 2000, either shorting the market in which you would have been destroyed or avoiding the market, in which case, perhaps all of your investors might have taken their money out of you and gone with some other manager.

Yeah, so Joe, that observation we found in the data in all of these historical episodes. So even in the cases where you were right, so meaning we had this price run up, we said it's a bubble, it's going to crash, and it ultimately did crash. We actually were off by five months on average, meaning that subsequent to the price run up, actually prices continue to run up on average of an average of an additional five months. and go up by an average of about 30%. So imagine you're short, the tech bubble. In the tech bubble, it was worse because if you used our signal,

you would have been short starting in March of 1999. And you would have lost everything just being short through April of 2000. But more generally, if you look across episodes, you would have been off by at least five months. in your research did you find anything that suggests what the catalysts are for an actual crash to occur in a bubble? Because as we've just been discussing, you know, if it's not a bubble, it's a bull run that just goes on for a long, long time. So what is the actual thing that tips it over? So the thing we did not investigate, and we are looking at now, is the exact timing.

and what are the characteristics around the crash that might help you be a really good timer of that crash. What we did instead was say, we've got these 40 episodes, you know, whether it was the utilities in the 1920s or the dot-com stocks or health care stocks in 1980s. What are the characteristics of that price run up, you know, extra speculation, volatility, issuance, a new paradigm? all that kind of stuff, does it help us forecast which of the episodes are going to ultimately crash? And there we found, I think, pretty useful evidence that you can predict, at least to some extent, which of those episodes are going to crash. So let's talk about some of these attributes. You identify a few very specific things that all these bubbles that crashed have in common. Why don't you tell us what a few of them are? Sure. What are the things?

that we found was a new characteristic we called acceleration. And acceleration really means that if the price has been going up even faster more recently, that's a good sign of a potential crash. The other thing we looked at was issuance. So, for example, lots of new firms coming online, IPOs, so think 1999, also 1920s. And then finally, One of the things we looked at was new firms versus old firms. So a lot of these episodes involve new firms. In fact, this is less well known, but the bubble in the 1920s was largely around the electrification of America.

So in 1920, there were 35 percent of households had electricity. By the end of that decade, it was 70 percent. There was the same kind of hype about electrification that we had around.com. And so we said, well, let's try to measure kind of the novelty of the industry at this time and whether there's a way to link that to the crash probability. Wait, I have a personal anecdote that I just remembered. Oh, I, no, Tracy. No, I don't think I've ever told you that it just, I actually have very direct, relevant personal anecdote that I just remember that relates to this. Go on.

So it was 1999, and I was my, I think a freshman or sophomore and. college and I like traded stocks a little bit with some money that I made for a summer job. And I invested in this company called Spyglass, which was a company that made software for TVs and phones to connect to the internet. And they actually had revenues and real business, but the stock didn't go anywhere. And then this other company called Liberate Technology, which was actually an Oracle spin-off, did the exact same thing. And they had almost no revenue or anything, but that stock went nuts.

and I just remember this. It seems like a good example of people. Spyglass had been around traded for several years. It just traded like dead money and liberate when bananas. And I couldn't understand the gap. But now hearing this, I'm reminded what you're exactly, what you're saying, the sort of the fetish for the new company rather than the old established one. Yeah, I think bubbles are sometimes about new companies and new industries.

They're always about a new story. And that's something that's very hard. to quantify because we're looking at all of these episodes over essentially a hundred years of data. So we can't quantify that very well. But new industry is a way to get at that. I mean, on your dot-com experience, there was an amazing phenomena where just adding dot com to your stock name added 70% to the stock price. So, Robin, you mentioned that when it comes to identifying actual bubbles, the acceleration of the price increases can be valuable or a valuable indicator and also

issuance. Is it because of this same dynamic? Because you basically just have a bunch of people jumping on the bandwagon? I think acceleration is measuring. Actually, we're not sure what acceleration measures, but we think it might be related to people coming in and buying following the very high already prices and past returns. The issue, I would say is related to firms understanding it's great times that people want to buy stock and they just want to supply that stock. Why not? So there's a lot of research already in finance showing that subsequent to a bunch of issuance that returns are low. But the thing that we have that's new is combined with this massive price run up, it's a pretty good predictor of a crash. Put knowledge to work and grow your business with CIT, from transportation,

to healthcare, to manufacturing. CIT offers commercial lending, leasing, and treasury management services for small and middle market businesses. Learn more at cIT.com. Put knowledge to work. You mentioned at the beginning of the episode that economists hate the word bubble. And I guess that's because... Economist and Joe. No, I like the word bubble.

I just think we should use it sparingly. I've been forced to get rid of it, that word, in multiple things that I've written over the years. Is that just because so many economists more or less have an efficient market's view of the world that at any given moment, the markets are perfectly pricing in all information and bubble is too judgmental in terms of markets are getting something wrong? I think it's that, but I think it's also what you mentioned earlier, which is that we don't really have a clear definition of a bubble. So is it a big price run up followed by a crash? is it just mispricing of some degree? So, for example, if the stock market is mispriced by 10 or 20 percent, is that a bubble or bonds a bubble? People don't really agree on the definition. And I think that's a strength of what we did was really fix a definition and then just see where it takes us.

Tracy, it reminds me of like one of our episodes we were talking about the definition of money and we were talking about how any person on the street could tell you what money is, except an economist who couldn't do it in a hundred pages. That's a really hard question. The same thing is with bubbles. Anyone can sort of define it except an economist. So away from the definitions issue, which I have a feeling we could talk about for a while, I kind of have a structural question, which is it's really great to sit and talk about what a bubble actually is.

But does it help anyone who's actually investing? because I remember way back in the day, City Group had a really good definition of a bubble, which was that a bubble is an asset that I get fired for not owning. If you see tech stocks accelerating by 100% over the course of a year and you don't have those in your portfolio, someone's going to yell at you, right, even if you think it might be a risky investment. How do you square that? I think you're raising a great set of questions about why these bubbles come to be in the first place. And to be fair, our research doesn't really speak to that question.

You know, my opinion, I think what you're saying is exactly right. These very large price runups, you actually have to participate. Actually, I did some work a few years ago looking at the tech bubble specifically. And one of the things that we found there was that we were looking at mutual fund managers. And we found that the old guard, so mutual fund managers over 45, were essentially loath to get into the dot-com stocks until the very end. So they actually performed very poorly. But the young people were involved sort of right from the beginning. So I don't know if that's career incentives, beliefs.

we pushed the line that it was a lot driven by beliefs that, you know, young people haven't experienced a crash. They don't say, well, we've seen this before. And we had some other evidence to support that view. But I think it's probably a bit of both of beliefs and incentives. And it also sort of, you know, people always talk about this, not necessarily with bubbles, but market turn when you talk about the final bears capitulate or the final bulls capitulate often being a sign of some sort of market turn. There's a very famous. There's a very famous. picture of Isaac Newton's holdings during the South Sea bubble where he is in at the beginning. So when prices are low, he gets out when they rise by some extent, let's say it's 30%.

And then prices keep rising. And he's looking around and presumably all of his friends are making a lot of money. And he gets in again at the peak and gets completely wiped out. I just googled this chart right now. I'm looking at it. It is pretty sad, and it really is sort of like the perfect emblem of – if you search Isaac Newton's South Sea bubble, you'll immediately see the chart online, and it perfectly describes the psychology of capitulating to a bubble at the worst possible times, both on the run-up and the way down. You see this in the ship's market, actually.

So if you go back to 2008, there was this incredible run-up and ship prices, so dry bulk carriers. And if you look at the data, there was actually this little price run-up in 2006, 2007. And a lot of people in the industry at the time said, wow, we've never seen prices this high. And they got out. And then prices went up a little bit more. And they said, ah, we must be wrong. It's a new paradigm. I love that.

So, I mean, but this kind of raises an important question, which is that are we just, are markets doomed to experience bubbles forever or will like we be able to inhibit human nature? Because to some extent, this is all about human nature, right? Like you don't want to miss out on the next big thing and you're fearful of missing the big wave of price increases. So I think they're here to stay. There's always a new story. I think we tend not to repeat history in exactly the same form.

And so if you look at all of the episodes that we did in the paper, they're all different in some way, but they're all similar in some ways as well. So I think whether you look in the U.S. or abroad, this is something that's going to be with us. Your paper looks specifically at equities, and there are certain characteristics of an equity bubble that can't be replicated with other asset classes, such as new share issuance or a fetish for new types of companies versus the old types of companies. I know it's not the direction of your paper, but is there anything in your paper that could perhaps be applied to non-equity bubbles, such as, say, you know, bubble in a precious metal or some other commodity or a current? or something like that. Yeah, so we didn't look at other asset classes. I've done in my other work some research on the credit markets. And there are some similar features in the data. So issuance actually is associated with poor returns.

So just to give you an example, when there are lots of low-rated firms, so junk debt and and so on, relative to investment-grade debt, that tends to forebode very poor returns in the credit markets more generally. So that, I think, would be kind of consistent with what we find in the equity markets. We haven't looked at commodities. In fact, that was suggested to us recently. There's hundreds of years of commodities prices. We might take a look at that. So, Robin, I have to ask, you've obviously been looking at many bubbles throughout history. What is your all-time favorite bubble? Dot com. I was in graduate school, and I was an MIT undergraduate, and I graduated in 1998,

and many of my classmates went to pets.com and all these kind of companies. And I was sitting in graduate school solving problem sets, and I couldn't believe that they were making all this money and doing all this excitement. And then it all came crashing down and I became a business school professor. So it was okay in the end, but it was a great experience just to watch and be part of it. You felt that visceral feeling of missing out. And I guess you didn't ultimately jump, drop out of school to become a... To join pets.com.

To join pets.com. But you must have felt that sort of like that thing in your gut that a lot of managers who try to avoid the the run-up felt. Oh, absolutely. One of the reasons I'm a behavioral finance economist is because I inherently feel all of these features of the financial markets. And so I find them fascinating and worthy of study. One other aspect of bubbles that people often talk about, and you look at these quantitative things, but certain cultural things. So I think, you know, there's the famous thing about sell.

the Shushine Boy giving stock tips. Or I remember in 99, my friend and I used to go to this pizza restaurant for lunch. And then during like late 99, they started showing financial TV. They turned the channel from ESPN onto, to watch the stock market. And that was probably in retrospect, quite a clear sign. Have you done any work on that? Because people always love to point out those signs and culture that sort of signify that something has moved beyond the financial realm and really become like sort of a cultural mania.

Do you think there are any interesting avenues down that to explore? So, Joe, I think those things are pretty hard to measure, but there's a saying that if you hear about it at the Harvard Business School locker room, it's probably a bubble. I think measuring this pretty reliably going back is difficult. We're trying to do that. So look at more interesting, kind of more difficult to quantify measures. So for example, what are people writing about in the press at the time? When it's a bubble, are people saying it's a bubble?

So we don't actually know the answer to that question. So that kind of data is becoming increasingly possible to access going back and to quantify. And so we're definitely going to be looking at that going forward. It's becoming very meta if we're talking about journalists overuse of the word bubble and then analyzing the word bubble in financial news stories. Anyway. Yeah, we'll take what we can get. All right.

Robin Greenwood of the Harvard Business School, fascinating research. You should check out the paper he authored entitled Bubbles for Famah alongside his co-authors, Yang Yu and Andre Schleifer. Really appreciate you coming on the podcast. Fascinating topic and a very sort of interesting introduction. to a topic that people talk about all the time, but that I don't think they have much real insight into. Thanks, Joe. Thanks, Tracy.

I really like that conversation, Tracy. And you know what I like? I feel like we may have actually given our listeners some useful information this time. As opposed to what we normally do? Well, I mean, you know, some of our past topics like the nature of cattle auctions and some of them, there might be interesting food for thought. But I feel like someone might actually make some smart decisions based on listening to Professor Greenwood's explanation of bubbles. For sure.

And I think one reason why bubbles are perennially fascinating, I think is the human nature aspect of it, right? Like it basically speaks to how we behave, right? Like we're greedy and then we're fearful and then we're too greedy again. And we're always sort of dealing with our natures in that way. But actually, so Joe, one thing we didn't get into that I wonder about is this idea that how do you know there's a bubble. Oh, it's when the, you know, shoe shine boys are giving stock tips. Do you think that's still relevant today in a market that's increasingly about passive flows? That is a really great question because, and I've kind of thought about this, you know, in the late 90s, stock picking and buying tech stocks and one of its tech stock portfolios.

such a cultural thing. Right. And now people are so into passive and ETFs and focusing on low fees as opposed to trying to beat the market. It does raise the question of whether, I mean, you have to figure at some point it all happened, but whether stocks will ever, when could they ever match the sort of cultural importance and the idea of picking your own stocks and all that stuff, just because people have gotten so into this sort of obsession with just low fees and ETFs. It's a great, you know, the sort of nature of people's relationship with the stock market has changed quite a bit. Right, because you see it, even with the Trump rally, you don't hear that much about, like, picking the right companies that are going to benefit the most. It's just like, oh, this is a growth

story. It's an inflation story by stocks. Yeah, I think it's a very different, people have a very different relationship with the stock market than they did during the bubble. And even, you know, the bubble was weird, but even going back to the 80s and 90s, I think there was much more interest in, oh, I like this stock or I like beating this. When you hear people talk about investments who aren't in the industry, and it's pretty rare for anyone to talk about them these days, it's almost always in the context of, you know, they're like interested in a robo advisor, how can they get low fees, or what is passive strategies. So we've really come a full circle on how people think about stocks.

But look, we know bubbles will come again. It just might be in a different form. Joe, what's the secret to spotting a bubble? Timing. Good one. That's a good one. On that note, sounds like a good time to wrap it up. This has been another episode of the Odd Lots podcast.

I'm Joe Wisenthall. You could follow me on Twitter at the stalwart. And I'm Tracy Allaway. I'm on Twitter at Tracy Allaway. Put knowledge to work and grow your business with CIT. From transportation to health care to manufacturing, CIT offers commercial lending, leasing, and treasury management services for small and middle market businesses.

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