The trouble with calling market bubbles

MICHAEL Burry, the contrarian investor Christian Bale played in The Big Short, earned his reputation by seeing what almost no one else could – that the “safe” label stamped on mortgage-backed securities in 2007 bore no relation to the rotting loans beneath them.

He was right, spectacularly so, and the call became the stuff of financial legend and a movie.

He has also, in the years since, wrongly predicted at least two recessions that never arrived. This raises an uncomfortable question. Was the first call genius, or was it just lucky timing?

And there is a harder question. We see so many predictions, such as where the market would be headed and loud bubble warnings. But how many times have forecasters been right, and how often have they simply been early, loud and wrong?

This is not an attempt to question anyone’s skill. Many economists, strategists and policymakers who have called market tops too soon are among the most respected voices in finance.

The problem is not personal; it is structural. Empirical evidence shows that identifying a bubble in real time is one of the hardest problems in all of financial economics, and the behaviour or actually acting on it is harder still.

Contested definition

Strip away the drama and a bubble is simple to describe: a self-reinforcing loop in which the price of an asset can continue to rise beyond reason, pricing in a potential that is more than anything it actually can produce. Momentum overrides discipline. The greater fool theory becomes the entire investment thesis.

That’s easy to define but devilishly hard to identify. Even academics cannot agree on the threshold.

A widely cited Yale study defined a bubble as a market that doubles and then surrenders most of those gains within five years. Based on its study of 21 developed equity markets over 115 years of data, it found bubbles to be remarkably rare – between just 0.3 and 1.4 per cent of all market periods, far below popular perception.

The more startling finding was what tended to follow a sharp run-up. After a market doubled within one to three years, a crash that erased the gains occurred only about 10 per cent of the time. In 26 per cent of cases, the market simply doubled again.

In plain English, a boom is more likely to be followed by a further boom than by a bust. Any warning system tuned to flag every steep rise as a bubble is, by design, a machine for generating false alarms.

What initially could easily be perceived as so-called bubbles often is a reflection of the emergence of new technology, companies or industries that go on to become the mainstream dominant force, generating real earnings and economic value.

Think of the biggest companies in the world these days and the decade or decades-long journey they have been on, from Walmart to Berkshire Hathaway to Google.

The most famous false alarm

The most celebrated bubble warning in history is also one of the clearest false positives. On Dec 5, 1996, US Federal Reserve chair Alan Greenspan asked aloud whether “irrational exuberance” had “unduly escalated asset values”. Markets flinched and the world heard a central banker calling the top.

He was wrong, at least on timing, which in markets amounts to the same thing. The S&P 500 nearly doubled, returning 31, 27 and 21 per cent over the next three consecutive years. The Nasdaq tripled.

An investor who heeded the warning and sold the day it was uttered would have forfeited a 105 per cent gain before the correction finally arrived in 2000. Greenspan himself cut rates in 1998, pouring fuel on the very fire he had flagged.

Even Robert Shiller’s landmark Irrational Exuberance, published almost exactly at the 2000 peak, made its core argument back in 1996 – four years and one enormous rally too early. His cyclically adjusted price-to-earnings (Cape) ratio has fared no better as a real-time alarm.

Wharton’s Jeremy Siegel found that between 1981 and 2015, the Cape signalled overvaluation in 416 of 422 months. An investor who obeyed it would have sat out one of the greatest bull markets ever recorded.

The crashes nobody flagged

If false alarms are one failure, silent collapses are the other. The 2008 crisis is the defining case. A scathing 2009 paper signed by eight economists, concluded the profession had been collectively blind to the risk building in housing and the plumbing that financed it.

A handful did see it but they were only partially right and often very early. Economist Nouriel Roubini warned the International Monetary Fund (IMF) in 2006 of a coming housing bust; Shiller had flagged the same in 2004. They were dismissed as outliers.

Tellingly, a Boston Fed study found that economists examining the identical data in the mid-2000s reached opposite conclusions. The signals – stretched price-to-income and price-to-rent ratios – were visible, but genuinely contested.

Japan is starker still. At its December 1989 peak, the Nikkei traded at 60 times earnings, its Cape neared 100 – twice the US extreme of 1999 – and the land under the Imperial Palace was reckoned to be worth more than all of California.

In hindsight, the signals were deafening. In the moment, the prevailing story that Japan was simply different was powerful enough to silence nearly everyone. As the bubble continues to expand, the loudest critics often give up too early and can never time the top.

What the evidence does and doesn’t allow

So can a bubble ever be spotted in advance? The most direct study, Bubbles for Fama by Harvard’s Robin Greenwood, Andrei Shleifer and Yang You, offers a qualified yes.

A soaring price on its own tells you almost nothing. But sectors that went on to crash shared a fingerprint: surging trading volume, a rush of companies issuing new shares, and price gains accelerating sharply in the final months. Taken together, those signals carried predictive power.

The deeper obstacle is behavioural, not statistical. Eugene Fama’s objection is logical: If a bubble was obvious, rational investors would sell and pop it, so its very persistence is evidence that few truly believe it. The incentives then make cowards of the rest.

As John Maynard Keynes observed, it is better for reputation to fail conventionally than to succeed unconventionally.

An IMF study documented that fund managers ride bubbles they privately distrust, because they are paid on relative, not absolute, performance, and standing apart from the crowd is the one truly unforgivable risk.

Why you should avoid predictions in general

The economist Paul Samuelson famously said economists have predicted nine out of the last five recessions. Recently that probably has deteriorated to 10 of the last two recessions. Beware of any expert that likes to predict too much.

The lesson is not that bubbles do not exist. It is that identifying one in real time, and acting on it more profitably than simply staying invested, is extraordinarily hard even for the brilliant, the well-resourced and the famous.

Being early, again and again, has proven indistinguishable from being wrong. The investor who fled US equities on Greenspan’s word surrendered three years of compounding for a correction that, when it came, still left disciplined holders ahead.

That is a liberating conclusion, not a defeatist one. If the top cannot be reliably timed, the winning behaviour is the unglamorous one: Stay invested, diversify so that no single narrative can sink you, rebalance with discipline rather than conviction, and treat your own certainty as the most expensive position in the portfolio.

In a game where even the experts cannot see the future, the durable edge is not in trying to make a better prediction. It is in following a better process.

The writer is co-founder and group chief investment officer of Endowus, an Asian digital wealth platform with S$15 billion in regional client assets across public, private markets and pension (CPF OA, SA and SRS)