Why bubbles are so hard to spot By Scott Sumner

There’s been a lot of discussion about the recent Chinese stock market crash. Most observers view the events through the lens of the “bubble” model of financial markets. This view claims that there are sharp price run-ups caused by irrational exuberance, and that rational observers can spot when the prices are out of line with fundamentals. In contrast, I believe it is very difficult to spot market irrationality at the time, and sometimes even in retrospect.

In some ways the recent Chinese boom and bust looks a bit like the 1987 stock market in America, when prices soared over the first 9 months, and then fell very sharply. At the time almost everyone thought it was a stock bubble, and they seemed pretty confident that the “wrong” price was at the peak, not the subsequent trough.

You would think that with the benefit of hindsight we’d learn who was right. We’d learn which of the two prices were clearly out of line. But a comment left by Brian Donohue a couple months back shows that even today it’s really hard to figure out who was right:

If you bought the S&P 500 at the peak (10/5/87) you’ve earned a 9.3% CAGR over the past 28 years. If you bought at the subsequent trough (12/4/87) you’ve earned a 10.8% CAGR.

Note that the S&P500 fell 31.75% over that period. Both of those subsequent returns look fairly reasonable to me. If you forced me to guess, I’d say the 9.3% return seems a bit more consistent with market efficiency (recall that inflation and nominal interest rates have fallen since 1987). And if I’m right this would imply that prices were more “rational” at the peak of the “bubble.” But either way, I think any fair observer would admit that even today it’s really hard to know what stock market valuation (S&P500) was appropriate in 1987—328.08 or 223.92.

Now imagine you were thinking about where Chinese stocks would be 28 years from today. Also recall that rates on alternative investments are now much lower than in 1987. Does anyone seriously believe it’s possible today to know which recent Chinese market valuation will be viewed as being more rational in 28 years, 5000 from a few weeks ago, or roughly 3000 today?

So I don’t find the “bubble” hypothesis to be useful. But just to be fair and balanced, I do believe that 1987 provides a very powerful argument against the EMH, indeed one of the most powerful arguments that I have ever seen. Not because 1987 was a bubble (it probably wasn’t), but rather because the more than 20% stock crash on October 19, 1987 was not accompanied by any new information that could justify such a sharp re-evaluation of equity values in 24 hours.

To summarize, there are pieces of evidence that seem inconsistent with the EMH. But the specific bubble argument is much weaker than most people assume.

PS. And don’t forget that while seeing which price was clearly wrong in retrospect is a necessary condition for the bubble hypothesis, it is not sufficient. For instance, in retrospect NASDAQ was overpriced in 2000, but perhaps that reflects new information about growth in IT.

PPS. The closing price on October 19, 1987, was 224.84, so virtually all of the crash occurred in a shorter period than Brian considered.

PPPS. And notice that there was no recession in America after the 1987 crash. Will China have a recession? Maybe, maybe not.