Bubble Psychology And Valuations

It Can’t Be A Bubble!

Articles claiming that the current situation in financial markets does not deserve the epithet “bubble” are a dime a dozen – we come across several every week since at least late 2013. Before continuing, we should point out that there is a big difference between recognition of a bubble and forecasting the timing of its actual bursting. For instance, we were well aware that there was a bubble in the late 1990s, but not only did it still take a good while before it hit its peak (a peak that was then retested in terms of the broader market half a year later), it also expanded considerably further before it did so, and only started collapsing in earnest in late 2000.

It is important to realize in this context that this particular bubble – the one in technology stocks that peaked in early 2000 – is not some sort of “standard measure” for what constitutes a bubble. It was certainly the most extreme stock market bubble in all of history in a major developed market (in terms of valuation expansion in this particular sector) – beating even the Nikkei’s famous 1989 blow-out by a huge margin. Again, only if one compares the tech sector’s then trailing P/E of more than 300 to the Nikkei’s trailing P/E of more than 80 in 1989.

In terms of the broader market’s valuation, the bubble peak in 2000 was less than half as spectacular as the Nikkei’s, but it was still the top of the greatest valuation expansion ever experienced in the US stock market. We merely want to point out here that it would be wrong to claim that “well, the year 2000 was a bubble, and therefore anything that doesn’t look quite as extreme as this one outlier isn’t”.

We came across another article of this type recently and want to discuss what we believe the flaws in its arguments are. The article in question is “Bubble paranoia on S&P 500 is a storm in a teacup”, which was posted at Saxo’s tradingfloor.com by Mr. Peter Garnry. Note here that we don’t want to make an argument about the likely timing of the bubble’s bursting or its potential for further expansion (that is a different subject) – we only want to discuss whether a bubble actually exists or not.

Opinions and Bubble Talk

One of the main arguments made in the above article is the following:

“Financial bubbles are characterized by the lack of different opinions, which is clearly not where we are today”

It is explained in the article that this is a reference to a recent increase in people’s belief in the existence of a bubble. This is usually reflected in a surge in references to bubble conditions in various financial news media. Mr Garnry (who was 15 years old at the time of the tech mania, and probably remembers the gaudy atmosphere at the time, which was indeed one of a kind) writes in this context:

“The most important point about bubbles is that they exist when no one seems to think they are there. In 2000, very few thought there was a bubble in tech stocks, but with hindsight it is clear that the bubble was massive. Again, very few acknowledged that there was a bubble in US housing in 2006-2007. The fact that three out of five people believe there is a bubble in US equities tells us that we are not in a bubble. When most bears have crawled back into their caves and maybe a few have come out as bulls then we need to worry, but not before.”

As a more grizzled veteran of the markets, we would immediately assert that this just isn’t true, based on anecdotal evidence alone. However, we can actually buttress it with data, and have actually already done so late last year (see “Circular Bubble Logic” for details). As a matter of fact, the exact opposite is the case – as a bubble matures and nears its peak, “bubble talk” increases. Anyone who experienced the tech bubble and the housing bubble on the front lines should be aware of this even if the studies proving it didn’t exist – but they do exist.

In addition to the Google Trend data we have shown in our earlier article, Bob Prechter has e.g. documented the prevalence of bubble references in newspapers as historical bubbles have progressed. Clearly, as a bubble climbs toward a frenetic peak, talk about bubble conditions begins to literally explode along with prices. Just because Alan Greenspan, Ben Bernanke and 95% of mainstream economists wouldn’t recognize a bubble if it bit them in the behind doesn’t mean that there aren’t a great many other people who do in fact recognize them.