Dr Qiusha Peng of the Cambridge Centre for Finance (CCFin) explains what bubbles mean to those in the financial world.
Accompanying the high-flying US stocks this year, the topic “bubbles” recently is a star guest in the media. Talking with different people, I noticed that interestingly, when hearing this word, most people first nodded their head, thought about it, and then said “wait a minute…”
What is a bubble?
Stocks may rally, foreseeing their strong growth prospects. Should we call them bubbles? Probably not. Bearing famous bubble episodes in mind, such as the dotcom boom, I find one definition in the academic literature that has closely described these events: speculative bubbles arise when investors are willing to pay a price higher than their perceived fundamental value.
How can I calculate fundamentals so I know there is a bubble?
Admittedly it can be difficult, especially for real estate properties. However, the key is the relative ranking. Specifically, investors may not know the exact level of fundamentals, but since assets are generally held by optimistic investors, they know that prices are systematically above the fundamentals. This coincides with a model-free examination of realistic episodes: if price exceeds the highest possible fundamental value, we can positively make a bubble conclusion. The Chinese warrants bubble (Xiong and Yu (2011, AER)) provides one such example.
Can we predict when bubbles will burst?
There’s an anecdote that Isaac Newton tried to ride the South Sea Bubble in 1720 – in at £3,500 and out at £7,000 – then re-entered the market and lost 20,000 pounds. He concluded, “I can calculate the movement of the stars, but not the madness of men”. Nowadays, the development of financial derivatives market provides us more information on investors’ beliefs. In a seminal work, using data on stock options, Bates (1991, JF) estimates the implied jump risk to gauge how likely the stock market crash in 1987 was expected by investors.