Asset Bubbles Day – October 14, 2013

Essay. We are celebrating “Asset Bubbles Day” today in affinity with the Royal Swedish Academy of Sciences (Reuters, October 14, 2013, Americans win Nobel prize for work on predicting markets) which has solved a difficult problem:

“There is no way to predict the price of stocks and bonds over the next few days or weeks, but it is quite possible to foresee the broad course of these prices over longer periods, such as the next three to five years. These findings were made and analyzed by this year’s Laureates”, the Academy said – ibid, Reuters.

There have been mistakes made in the past and, as in the past, the implications for today’s findings in “asset bubbles” could have a profound effect on the capital markets and the investment behaviour of investors who are not economists but no impact on economists who are not investors. Indeed.

For example, Mr. Fama has shown that it is impossible to “beat the market” using the methods of “equities analysis” and that has led to the development of index funds and ETFs and, it is said, that most households [actually] put their savings in index funds – ibid, Reuters.

On the other hand, Mr. Shiller has shown that there’s more predictability in stock and bond markets in the long run and that has encouraged the creation of institutional investors, such as hedge funds, that take bets on market trends and Mr. Hansen (in the 80’s) has developed a statistical method to better evaluate these theories – ibid, Reuters.

S&P 500 Asset Bubbles
Courtesy: Kevin Lansing, Federal Reserve Bank of San Francisco, October 2007

Economists use the term “bubble” to describe an asset price that has risen above the level justified by economic fundamentals which is rationally measured by the discounted stream of expected future cash flows that will accrue to the owner of the asset.

The dramatic rise in U.S. stock prices during the late 1990s (the dot-coms) and U.S. house prices during the early 2000s (the NINJA-financed mortgage debacle) have both been described as “bubbles”.

Bubbles have also been described by Mr. Shiller as a type of psychological malfunction and like mental illness there’s a tricky gray area between being really sick and just having a few problems.

Mr. Shiller at the World Economic Forum in Davos, Switzerland

Based on the Checklist, we’re probably in an asset bubble right now. Should interest rates on treasury bills rise, there will be a sell-off of trillions of dollars of low yielding bonds so that investors can take a rational immediate loss rather than one that might be spread over many years.

S&P 500 Total Real Returns – 3, 5 & 7 Year
Data Courtesy Of: Robert J. Shiller, Yale University, 2013

Moreover, we might also expect a rational flight of capital from the equity markets to the burgeoning bond markets.

And the question is, Are we really sick or are we just having a few problems?

Going to the data, the trend of Mr. Shiller’s data supports the development of the seven-year bubble by immediately preceding 5- and 3-year bubbles – look for the sequence yellow, green, brown in the chart at the left. Please click on the chart and again to make it larger.

And the indication to date is that “we are having problems” and that although there is “anxiety”, we are far from being really sick.

Efficient Frontier (B)(N) Boundary Open

We also note that this more realistic understanding of the markets as something more than just a crazed and desperate optimization of investor greed and paranoia demonstrates the “societal standard of risk aversion and bargaining practice” and that there is a specific way to measure that within the (B)(N)-paradigm that we use for making investment decisions.

For more on what risk averse investing has done for us this year, please see our recent Posts on The S&P TSX “Hangdog” Market or The Wall Street Put or specialty markets such as The Dow Transports & Utilities or (B)(N) The Woods Are Burning, or for the real class action, La Dolce Vita – Let’s Do Prada! and It’s For You, Dear on the smartphone business.

And for more stocks at high prices, The World’s Most Talked About Stocks or Earnings Don’t Matter – NASDAQ 100.

Postscript

We are The RiskWerk Company and care not a jot for mutual funds, hedge funds, “alternative investments”, the “risk/reward equation” and every other unprovable artifact of investment lore. We have just one product

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Disclaimer

Investing in the bond and stock markets has become a highly regulated and litigious industry but despite that, there remains only one effective rule and that is caveat emptor or “buyer beware”. Nothing that we say should be construed by any person as advice or a recommendation to buy, sell, hold or avoid the common stock or bonds of any public company at any time for any purpose. That is the law and we fully support and respect that law and regulation in every jurisdiction without exception and without qualification to the best of our knowledge and ability. We can only tell you what we do and why we do it or have done it and we know nothing at all about the future or the future of stock prices of any company nor why they are what they are, now. The author retains all copyrights to his works in this blog and on this website. The Perpetual Bond®™ is a registered trademark and patented technology of The RiskWerk Company and RiskWerk Limited (“Company”) . The Canada Pension Bond®™ and The Medina Bond®™ are registered trademarks or trademarks of the Company as are the words and phrases “Alpha-smart”, “100% Capital Safety”, “100% Liquidity”, ”price of risk”, “risk price”, and the symbols “(B)”, “(N)” and N*.