What is bubble theory?

Bubble theory (n.)

Belief that stock or asset prices (e.g., real estate) will sometimes inflate to levels well beyond reasonable valuation before bursting and, following that, returning to normal.

Source: Barron’s Dictionary of Finance and Investment Terms, 7th edition, 2006

/ˈbəb(ə)l/noun

• a thin sphere of liquid enclosing air, etc.
• a situation in which investments, sales, etc. increase rapidly and then collapse.

Source: The Canadian Oxford Paperback Dictionary, 2000

/ˈTHire/noun

• A supposition or a system of ideas intended to explain something, especially one based on general principles independent of the particular things to be explained.

Source: The Canadian Oxford Paperback Dictionary, 2000

Dutch tulip mania in the 1630s—when tulip values reached astronomical levels and a futures exchange was created to buy and sell them through contracts, with no delivery—is often cited as the first economic bubble.

The term “bubble,” however, officially popped up as an economic term almost a century later when the British parliament passed the June 1720 Bubble Act. The legislation was meant to regulate companies raising capital and prevent corporate fraud, but it ended up contributing to England’s first major market crash, or what’s known as the South Sea Bubble.

Despite these and other historical examples (including the 1930s recession, the dot-com crash in 2001, and the 2007-08 subprime mortgage crisis), the term “bubble” can be interpreted in different ways— as a useful risk category for mispriced assets or, potentially, as a distracting term for events that are as unpredictable as they are rare.

In a 2015 paper, Yale School of Management professor William N. Goetzmann defines a financial bubble as a boom that went bad. More precisely, he measures bubbles as an increase in market levels of at least 100% over a one- to three-year period, followed by a drop of at least 50% in the following year or, for wider analysis, the next five years. Analyzing data from 1900 to 2014, he concludes true bubbles are “extremely rare”: using the three-year inflation period, he found 10.42% of boom markets had crashed to half their levels after five years.

“After a stock market boom of at least 100% in a single year, the frequency of doubling in the next five years was significantly greater than the frequency of halving,” he wrote.

His study “can be interpreted as focusing on one common notion of a bubble, but not the only one,” he says, as bubbles can build and burst at different intervals, or even not burst at all.

Different definitions

Gap between price and value. Craig Geoffrey, assistant professor in finance at the University of Toronto’s Rotman School of Management, defines bubbles based on a fall in price, which may or may not be preceded by a steep rise. A bubble can occur when there’s “an abnormally large difference between price and value” for an asset, he says, and the term can be used to describe the risk profile of an asset. The meaning of “abnormally large” varies depending on asset classes, time periods and economic conditions, he says.

Geoffrey doesn’t consider bubbles to be rare. Cannabis, private equity, housing and employment can all be thought of as bubbles, though this depends on how broadly a market is defined, he says—as all stocks, or just tech stocks, or even just FANG stocks, for example.

What about market efficiency? Benjamin Felix, associate portfolio manager at PWL Capital in Ottawa, favours Eugene Fama’s efficient market hypothesis, which doesn’t believe bubbles are prolific. “A bubble is based on prices being much higher than the intrinsic value of the asset, but what is the intrinsic value?” he says. “The intrinsic value of an asset is based on the present value of the expected future earnings or cash flows for that asset, and it’s not a bubble if asset values change based on those expectations.”

While prices and the market are not perfectly efficient, “there’s no evidence that anyone can consistently exploit that” through identifying mispricings and constantly beating the market. He points to the tech bubble, which “was driven by expectations for the internet that, at the time, seemed rational.” While the opposite was true, “at the time, nobody could have known that,” says Felix.

How to help clients

Take a long-term view. If a client were to ask whether we’re in a bubble, Felix would explain his “long-term, rational” investment approach, which is based on picking and sticking with suitable investment mixes through market cycles. He would also reference materials that illustrate why “high valuations now don’t necessarily mean low returns in the future,” he says.

Address their fears. If investors succumb to fear of missing out or market speculation, says Geoffrey, it can lead to them jumping in and out of markets—and such behaviour can contribute to bubbles forming. Behavioural tics tied to pride, jealousy, fear and greed, which aren’t modeled in efficient-market theories, can lead to issues like present-bias preferences, false confidence and herding, as well as “panicky selling” in dipping markets, says a 2011 paper from Netherlands-based Rabobank that examines the occurrence of bubbles over the past two centuries.

When managing a portfolio and its exposure to rising or falling markets, says Geoffrey, it’s better to help clients avoid a “gambling mentality,” and encourage them to focus on pre-determined dollar goals and needs—versus “periodic returns they’re earning.”