Opinion: The Stock Market’s Plunge isn’t the Sound of a Bubble Bursting
Evidence shows the stock market hasn’t been in a bubble
Whatever it is that’s bringing the stock market down sharply, it’s not the bursting of a bubble. That’s because the recent market — overheated and overvalued as it has been — doesn’t even come close to past market bubbles.
And the stock market’s plunge over the last week — more than 2,000 points on the Dow Jones Industrial Average DJIA on an intra-day basis — also doesn’t compare to the carnage of a bubble bursting.
That at least is what I conclude from academic research into the precursors of past market bubbles.
Consider first a study that was published in 2006 by Malcolm Baker, a finance professor at Harvard Business School, and Jeffrey Wurgler, a finance professor at NYU. They devised a number of objective indicators of irrational exuberance that, in backtesting, were highly correlated with bubbles such as the 1929 stock market crash and the bursting of the Internet bubble in early 2000.
Here are several of those indicators:
• Number of IPOs: One measure of irrational exuberance is lots of companies going public, and the current market is far colder. In 1999, for example, the last full year before the internet bubble burst, there were 477 IPOs, according to Jay Ritter, a finance professor at the University of Florida. In 2017, there were 108.
• Dividend premium: This is the valuation differential between speculative newer firms (as indicated by whether or not they pay a dividend) and the more established dividend payers. When exuberance is high, Baker and Wurgler found, non-dividend-payers have higher ratios than payers. At the top of the Internet bubble in early 2000, for example, non-dividend-payers had on average a 43% higher price/book ratio than those paying a dividend. Today it is the dividend companies with the higher valuations — 7% higher, according to FactSet, among stocks in the S&P 1500 index.
• Equity share in new issues: Yet another exuberance indicator that Baker and Wurgler focused on is the extent to which corporations are turning to the equity market instead of the bond market to raise capital. Exuberance is at a high level whenever corporations are disproportionately turning to the stock market to raise capital. Wurgler, in an email, said that the equity share for 2017 was just 7.3%. “In the sweep of history,” he noted, “this is quite low.”
A second study focused on price runups that were so extreme that a crash became likely. Its authors were Robin Greenwood, a finance and banking professor at Harvard Business School and chair of its Behavioral Finance and Financial Stability project; Andrei Shleifer, an economics professor at Harvard University, and Yang You, a Ph.D. candidate at that institution.
The researchers defined a bubble as a sharp price runup over a two-year period followed by at least a 40% drop over the subsequent two years. When the price runup is 100% or more, they found the probability of a crash rises to 50%. When the price runup is at least 150%, that probability becomes 80%. As price runups become even bigger, a crash becomes “nearly certain.”
As an example, I applied their research to bitcoin BTCUSD in late November 2017, writing that — given the crypotcurrency’s 2000+% gain over the prior two years — it was “nearly certain” that bitcoin would crash. Bitcoin is now down 65% from its December 2017 high.
The stock market’s recent gain hardly shows up as a blip on a bitcoin bubble chart. At its Jan. 29 all-time high, for example, the S&P 500 SPX, had risen 48% over the trailing two years. That hardly translates into any significantly increased probability of a crash, according to the researchers.
The bottom line: Even if the bull market has come to an end and a bear market has begun, the data do not justify a claim that the market was in a bubble that has now burst. The only real bubble, quite frankly, may have been in all those assertions that the bubble was real.