Over the last decade, I’ve done numerous posts explaining why the bubble hypothesis is not useful. The bubble hypothesis claims that asset overvaluation is often “obvious” in real time, and implies expected future underperformance, on average. I’ve also argued that the lack of successful “bubble funds” is an indication that asset price bubbles do not exist. If they did, then mutual fund managers would be able to outperform the market by taking short positions in a wide variety of assets experiencing a price bubble.
In 2017, Joe Weisenthal had an amusing idea for a contrarian investment:
[B]ack in 2017, I did joke on Twitter that someone should create a portfolio consisting solely of assets that pundits love to warn are in a bubble. The premise was that people always call things that have gone up a lot a bubble, and most of the time those calls are wrong (or at least very premature), so it makes sense to buy them all as a basket.
It turns out that someone took his advice:
Paul McNamara, who runs an actual nonpretend hedge fund at GAM, went ahead and constructed a hypothetical bubble portfolio a few days later, consisting of things such as Netflix, Tencent Holdings, Tesla, a Canadian apartment REIT, a London property company, the Grayscale Bitcoin Trust, the Argentine century bond, Japanese government bonds, long-term zero-coupon U.S. Treasuries, and so forth—you know, all the things people have been calling overvalued for years. Some of the positions have blown up (thanks, Argentina), but by and large, performance has been robust.
Note that this portfolio is the opposite of what I proposed. I suggested a fund that took a short position on “bubble” assets, whereas McNamara’s hypothetical portfolio took a long position.
Suppose I am wrong, and that mutual funds taking a short position in bubbles really could systematically outperform the market. In that case, those funds would become very popular and this would quickly tend to move asset prices to their correct level. So even if the bubble hypothesis were ever to become “true”, its validity would only last for a brief period, before being competed away by greedy investors. Bubbles would last as long as a child’s soap bubbles blown into hurricane winds.
READER COMMENTS
robc
Sep 20 2019 at 3:48pm
Didn’t John Paulson basically do what you are suggesting by shorting the housing market in 2007?
Scott Sumner
Sep 20 2019 at 6:32pm
Yes, and he was highly successful. The fact that you’ve heard that story kind of proves my point, doesn’t it? If it were common, would you even know about it?
Michael Sandifer
Sep 20 2019 at 11:32pm
Also, Paulsen didn’t have much success in the years that followed
zeke5123
Sep 21 2019 at 9:33am
If I am losing pennies 99/100 but picking up a 100 dollar bills 1/100 times, then providing my bank roll is large enough I will come out ahead.
The question is whether Paulson (a) is only losing pennies and (b) whether he is picking up 100 dollar bills when he is right.
Peter McCluskey
Sep 20 2019 at 8:15pm
Your claim seems to depend on an ability to cheaply short bubble assets.
The paper “The Shorting Premium and Asset Pricing Anomalies” (http://ssrn.com/abstract=2387099) seems to say that fees associated with short selling are high for stocks that will underperform. This indicates to me that markets do have some ability to detect bubble-like prices, and that a combination of risk and fees limits the market’s ability to prevent bubbles.
Or was your point mainly that pundits do no better than random guessing? Tetlock showed that long ago.
Matthias Görgens
Sep 20 2019 at 11:05pm
Yes, the transaction costs and fees for shorting are often pretty high.
Despite economists’ appreciation, the public at large doesn’t like short sellers more than any other dreaded speculator.
Matt Levine’s Money Stuff often covers the problems short sellers have. It’s especially inconvenient when the company you are shorting goes so bad, that trading in their stocks is halted.
Mark Z
Sep 20 2019 at 11:12pm
The paper seems to say that short fees are predictive of even returns net of fees, so would a high fee really be a major deterrent, if one can expect to be compensated by higher returns. “Arbitrageurs find these overpriced stocks and short them. In so doing they borrow these stocks’ shares and thus drive up their fees. Hence, a stock that has a high fee is one that arbitrageurs strongly believe is overpriced and are willing to pay a lot to short.”
They also note that 80% of stocks have low fees.
Scott Sumner
Sep 21 2019 at 11:54am
In that case you could set up a fund that takes short positions in negative bubbles.
James Gibson
Sep 21 2019 at 6:23am
It’s not enough to just recognise that the market is overvalued (which is already difficult enough). To successfully short the market, you need take a specific position (and be correct) on the dimensions and timing of the bubble. And since bubbles are driven by human psychology and animal spirits, it is almost impossible to make the right bet.
Let’s not forget John Maynard Keynes: “The market can stay irrational longer than you can stay solvent.”
Mark Z
Sep 21 2019 at 3:53pm
The business cycle is supposed to be on a roughly 7-11 year period. That’s not a terribly long time for markets. It doesn’t seem that difficult for plenty of institutions and people to remain solvent for long enough to take advantage of bubbles, if they are indeed driven by animal spirits.
Scott Sumner
Sep 21 2019 at 6:32pm
There are many so-called “bubbles” occurring in many different markets at any point in time. There’s no need to wait, just load up with short positions in various bubbles.
Michael Rulle
Sep 21 2019 at 12:11pm
My definition of a Bubble is when the price of an asset is extremely improbable to be correct and a rational person will be able to identify it in advance. ( “Extremely Improbable” is like a limit in Calculus—-it approaches impossible but never gets there).
This is clearly a vague and almost meaningless definition. But not entirely. For example, one cannot call the price of an NBA team, or a Jackson Pollack painting, examples of a Bubble. Any asset which is desired for non-cash flow reasons cannot be a “Bubble” asset. Another example of “not Bubble” is when Market participants are trying to corner a market against another group trying to prevent it. This is high stakes rational game theory in action. An example of this is the “March/April” natural gas spread which went to extremely improbable values (Amaranth goes bankrupt 2006).
But what about assets that are only desired for their long term (let’s call long term 100 years) earnings/cash flow generating ability? While extremely rare, it is possible to identify a Bubble price. It is also extremely difficult to generate a profit by identifying it. By definition, if it is a Bubble, how is it possible to predict when it will burst? One can avoid owning them, however.
I do not believe housing prices were a Bubble. (It did not fit the criteria of being “extremely improbable” to be correct).
I did believe most NASDAQ prices in 1999 were Bubble prices as I define it. Let’s assume I did my calculations accurately. I will use Cisco as an example. It’s price implied that if GDP grew at 4% a year, CSCO earnings would be equal to GDP in 20 years. Or, if CSCO would be 2-3 times it’s current percent of GDP in 20 years, GDP would have to have grown at about 12% per year for 20 years. These are not precise, but were generally correct.
‘That seemed to be extremely improbable. In December of 1999 I really believed this was obvious—-but certainly was not going to short anything. Beginning then, I rolled 3 month collars around my S&P portfolio for the next 3 years. Was not efficient but better than being long outright, and I would never recommend such a strategy.
I even, when asked by friends what to do in equities, literally begged them to not put money in the market. A friend of mine had sold his company and asked my opinion. I never give opinions——it is silly—-except then. To this day he “thanks me”—-which is odd—-and it does give me pause—-but I would have felt terrible if I had not told him.
That was the only time in my awareness of history that I believed there was a knowable Bubble. Who knows? S&P peaked in 7/2000 and NASDAQ in 3/2000. The former dropped 60+%, the latter 85+% over the next 3 years. CSCO went from 8 to 78 and back to 8 again in 2 plus years. It is now at 49.
We all know, that almost everyone was calling it a Bubble at the time. Did I think NDX would drop 85%? No—-I had no forecast or any real opinion as to the right price. To me, any current price could be + or – 30% and it still would be rational—-and maybe more. But not in 1999-2000.
Scott Sumner
Sep 21 2019 at 6:36pm
I’m not sure where you got your Cisco numbers, but they are obviously wrong. Nasdaq is currently around 8000—are you short Nasdaq?
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