Tuesday, May 27, 2008

How to Spot an Economic Bubble

One of my posts last week discussed the possibility of an economic bubble in the commodities market. Co-incidentally, a couple of days later I read this article in the Wall Street Journal which offered some very interesting insight into the mechanics of an economic bubble and some tips on how investors can spot them.

A couple of key insights I took from the article:

First, based on trading volume and comparing spot and futures pricing, the researchers quoted in the article come to the conclusion that commodities are expensive but are not in bubble territory.

Second, a very fascinating and counter-intuitive conclusion of the research is that in many cases, rational investors who spot a bubble would do better to go along with it, rather than try to attack it. Their recommendation to skeptical investors: if you spot a bubble, ride it to the top, get out quickly and start placing bets against the bubble, when things turn south. Interesting.

This reminds me of my business school accounting professor who is 1999 used to come to class frustrated that the stock market stopped making sense, that companies showing massive losses were achieving stratospheric valuations... and that his short positions were causing him painful losses. The market turned south only a few months later, but as the article quotes: the market can stay irrational longer than you can stay solvent... :-)


DanC said...

I always have issues with calling anything a bubble. That implies that the market isn't efficient, because it is supposedly overvaluing things. In this case, the commodity price is what the market says it is. Therefore, it can't be overvalued. It's actually impossible for it to be overvalued by definition (ASSUMING we believe in efficient markets).

You're right that there may be news that comes out in the future that causes commodity prices to go down. I think that's likely. But then that's not a bubble bursting. That's the market accounting for new information, like it always does, and moving prices accordingly.

Shadox said...

Danc - the markets are not always efficient. There are numerous examples of market inefficiencies that have been documented in academic studies (e.g. the tendency of new IPOs to underperform the market in their first 5 years). Yes, prices are determined by the markets, and in that sense buyer and seller are always paying a fair price. However, occassionally the prices cannot be justified on the basis of fundemental economic analysis (e.g the tulip mania bubble is the best example of this even if it is 300 years old).

Bubbles collapse not because of the release of certain specific pieces of news, but because of a fundemntal shift in the psychology of the trading public. The term bubble is often used in the context of valuations being driven by public sentiment, and by speculators' expectation that prices will continue to appreciate merely because they have done so in the past.

When sentiments shift, the market corrects quickly and dramatically. If you call such shifts "news" then you are correct, and there is no such thing as bubbles, but for the rest of us a "bubble" is a term used to explain unreasonable price appreciation driven by speculation and with little connection to economic fundementals.

DanC said...

Markets are not 100% efficient. I agree with you on that. IPOs are a good example of that. But commodities, which are heavily traded and followed by people around the world, are unlikely to have any inefficiencies (although they still might), and therefore IPOs are a bad comparison.

I disagree that prices can't be justified sometimes. They are justified by the market. You and I might not want to pay the high prices, but that doesn't mean that because we believe they are too high that they, in fact, are. The market justifies prices. Period.

Think about it. If "economic fundamentals" (your loose term which is the equivalent of my even looser term "news") set market prices, and the fundamentals say that the expected current value of future cash flows as it stands right now means that oil needs to be priced at $140/barrel, then that's the price of oil. It doesn't matter what about the economy causes that price, whether it's speculators or increased demand or anything else.

There are shifts, regardless of what causes them, that will probably cause commodity prices to drop, and will definitely cause them to move. That invisible hand is what I call news. I didn't really explain that well in my first comment.

Your argument that bubbles collapse because of fundamental shifts in psychology (and it's unclear what effects psychology has on trading, although it makes sense that it does have some effect)...I would lump that into my general term news, and therefore the market is taking that into account and is pricing it right in. No matter what you call it, I would argue that the info is translated to pricing.

We agree on the basic idea that commodities are probably going to drop in price. But, the word bubble implies inefficiency that I don't agree with. If the price is set and agreed upon in the open market, it is efficient, no matter what anyone else thinks. That includes you, me, cable news, or our opinions of economic analysis (much more opinion there than people realize).