Do Asset-Bubbles Exist? Can They Be Managed?

In this winter of anxious anticipation (following the Pfizer
PFE
vaccine announcement on Nov 9), the financial press has been dominated by two similar-but-different “bubble” stories: Tesla
TSLA
, and now GameStop
GME
. They are oddly linked. They are also misunderstood.  

The Tesla Case

On Nov 16, S&P Global announced that Tesla would be added to the benchmark S&P 500 index – which triggered a rise of 116% in the price of the stock in the next several weeks, adding $450 Bn in market value. Trading volumes exploded. On Dec 18, the stock set a new all-time record for the dollar volume of trading for a single company in a single day. For most of December, Tesla-talk dominated the financial press.

This frenzy occurred despite the absence of any game-changing announcement from the company. The share price was clearly disconnected from the business fundamentals. Tesla’s price/earnings ratio reached almost 1400 to 1. What profits there were came from gaming the environmental regulatory system by selling emissions credits to the company’s competitors. Tesla has never made a penny of profit manufacturing and selling cars. Its 2020 gross margin is lower than it was in 2016. Its “real business” (apart from the credits) has lost $7 Bn over the last five years.  

Unsurprisingly, then, as the year came to an end, the word “bubble” began to appear in the media accounts of the company.  

 The GameStop Case

Then, on the morning of January 13, a new story took over. The mediocre stock of a truly mediocre company suddenly doubled in price. It doubled again over the following week. On January 26, Elon Musk (of all people) offered one-word, double-exclamation commentary:  “Gamestonk!!” The stock detonated, engulfing the punditry – e.g., 

  • “Just about an hour ago, we wrote about how a flailing video game chain CameStop went from losing $470 million to become a $7.05 billion company by market cap. Now, Elon Musk just added fuel to the fire. In a tweet that links to the subreddit chat room called r/WallStreetBets, Musk exclaimed: “Gamestonk!!” Musk’s tweet sent GameStop soaring after hours to $240.” 

The shares rose another 500% in two days.  

GameStop traded (briefly) at more than 4000% above the Jan 2020 level. Once again, there were no significant fundamental announcements from the company to justify this move. GameStop’s last previous press release (January 11) had blandly reported a 3% decline in sales. The company’s prospects are objectively dismal. Revenues are down 40% in the last 8 quarters. Operating profit margins are negative. Cash flows are negative. They’ve lost over a billion cash flow dollars in the last 24 months. The business has been in decline for years. 

    

Again, the “bubble” label took over the headlines.

With Congressional Hearings set to begin February 18, the attention will continue to build. Where Tesla has rocket ships and Elon Musk, GameStop has scandal, suicides, and litigation. The frenzy has riveted investors, regulators, Congress, the broader public, the social media. Even Hollywood.  

But are these anomalous price movements best understood as “bubbles”? What does that label mean? Or is something else going on?  

The Classic Questions 

There are three long-standing questions about stock market bubbles. 

  1. Do “bubbles” exist?
  2. If they exist, can we spot them accurately?
  3. If so, should we (can we) do anything about them?  

Do Bubbles Exist? 

Of course they exist. But what are they? 

The cleverest answer, by far, was cited in a recent column, written by the chief global equity strategist for Citi:

A simpler definition

  • “An asset bubble is… a situation in which asset prices appear to be based on implausible or inconsistent views about the future. It could also be described as trade in an asset at a price or price range that strongly exceeds the asset’s intrinsic value.” 

Viewed in this way, simply, as a severe mispricing event, the GameStop chart above is an existence proof of this sort of anomaly.

What is a mystery are the continued denials of the “Efficient Market Hypothesis” Cult. They believe that markets always find the correct price, corresponding to the “true value” for any asset that is traded in sufficient volume. For adherents of the EMH, surviving in the protected backwaters of academia, there can be no such thing as a bubble in “today’s uber-efficient markets,” as the former president of the American Finance Association wrote in a recent op-ed for the Washington Post:  

  • “Are there bubbles? Are markets really irrational? Markets are generally very good at providing price discovery, so I am firmly in the camp that markets are rational.”

  But the EMH has no explanation for the sort of thing we see in the GameStop chart. The drivers of the process lie outside the theory. 

  • “The efficient market hypothesis cannot explain economic bubbles since according to the theory, bubbles can’t exist.”

The word “bubble” itself is controversial. But episodes of severe overvaluation clearly do occur. The sequel – an inevitable collapse – is also well-documented. Indeed, it has already occurred in the GameStop case, and may be confidently projected for Tesla as well – though the timing of the recalibration, like the timing of all market movements, is hard to call.  

Can Bubbles Be Identified?

The diagnostic problem is that if we define a bubble as an obvious disconnection between the share price and the company’s “intrinsic value” – in other words, a severe mispricing – it can be very difficult to discriminate among different types of pricing anomalies. Stocks can get ahead of themselves without entering the bubble zone. Where is the line crossed, between healthy “animal spirits” and mass psychopathology?

The conventional wisdom is often pessimistic. Knowledge comes only too late. 

  • “…because it is often difficult to observe intrinsic values in real-life markets, bubbles are often conclusively identified only in retrospect, once a sudden drop in prices has occurred.”

Academic theorists derive a similar pessimism from their faith in the EMH.

  • “Fama, like other proponents of efficient markets theory, is dismissive of claims that it is possible to consistently identify asset bubbles before a collapse.”

The general media often echo this view, pointing out that “bubble” predictions are common, and commonly wrong. Hence – trying to spot bubbles is said to be challenging:

  • “The Extraordinary Popular Delusion of Bubble Spotting…Investors should always guard against the glib assertions of pundits who claim they can detect bubbles before they burst.” – WSJ 
  • “Being right about past bubbles does not automatically ensure that you will be right about the next” – Robert Shiller, Yale Nobelist
  • The dilemmas of dealing with bubbles grow more intractable. Some booms do not go bust, making it harder to spot ones that will.” – The Financial Times
  • “On any given day, there are lots of people predicting various doomsday scenarios (spend a little time on finance Twitter to see for yourself). How do you know which one is right among all the cranks? And maybe today’s crank will look brilliant tomorrow. As they say about broken clocks…” – Former Head of the Minneapolis Federal Reserve Bank

Bubble-detection pessimism has been codified by central bank economists, working at the macro-economic level, who have reached a consensus that detecting market-wide bubbles is technically impossible. Here is how one Federal Reserve study summarized the matter:

  • “Can asset price bubbles be detected? This survey of econometric tests of asset price bubbles shows that, despite recent advances, econometric detection of asset price bubbles cannot be achieved with a satisfactory degree of certainty. For each paper that finds evidence of bubbles, there is another one that fits the data equally well without allowing for a bubble. We are still unable to distinguish bubbles.”

Can Anything Be Done ?

Pessimism easily translates to policy-nihilism. The common answer to the question here is to stand aside. Let the market clear – or, in the infamous recommendation of Herbert Hoover’s Treasury Secretary (Andrew Mellon)… “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.” Liquidate the short-sellers. Liquidate Robinhood. Liquidate Reddit.

Some journalists, and even some policy-makers, fall in line with this, adopting a tough-talking do-nothingism. The lead financial market columnist for the Wall Street Journal put it thus:

  • “I don’t think we need to worry too much about the rough-and-tumble world of WallStreetBets… Over time they’ll learn not to gamble what they can’t lose, or they will lose it. Plenty of weird things that conflict with efficient markets are regarded as perfectly normal and acceptable… We can learn to live with a few more bizarro stock moves thanks to Reddit.”

The ex-Chairman of the SEC seems to think that proper disclosure absolves the regulatory requirement: 

  • “’You can sell garbage to the public as long as you say to the public, ‘This is garbage and you’d be an idiot to buy it, but would you like to buy it?’ said Harvey Pitt, a former SEC chairman.”

The WSJ offers non-advice:

  • “Expecting policy makers to predict the future by popping “bubbles in the making” is probably a bad idea.”

A more informed view comes from Neel Kashkari (former head of the Minneapolis Fed) who analyzed several “bubble” events, and bubble-control policies, in several countries – in a very interesting and readable essay. He concluded that

  1. Detecting a bubble is extremely hard
  2. Even when the mispricing is “obvious” – the timing of the inflation/deflation cycle is not
  3. Policy instruments are not very effective, even when wielded with precision – and can have harsh side effects. 
  • “When asset prices are climbing rapidly, they can be very difficult to slow down, even with policy tools that are targeted squarely at the asset class. That suggests to me that if central bankers were to try to use monetary policy to slow those bubbles down, the rate increases necessary to be effective would likely be large, resulting in high economic cost to the rest of the economy.”

But I think that whether this nihilism is blunt (“liquidate!”), or nuanced, it falls short. There is a real problem here, and a big part of the problem is that we don’t understand the nature of the phenomenon.

Labels Aside, What About Tesla and GameStop?

When we see a P/E ratio of 1400 (the Tesla case), or a share price rise of 4000% against a background of declining revenues, profits, and cash flows (GameStop)… and when the price rise is not associated with meaningful fundamental news about the company, it is easy enough to declare that a significant pricing anomaly has developed. Whether we call it a bubble to not, it creates a dangerous situation for ordinary investors (and sometimes for professionals too). 

Moreover, as the Congressional hearings and the general aftermath of the GameStop episode are already making clear – severe investor losses, and even suicides – the costs of pricing anomalies of this sort can be significant and painful, and – to adopt the political theme-du-jour — they seem to be meted out inequitably. This sort of frenzy always seems to produce more losers than winners, and the victims skew towards the retail end of the market.

There would seem to be a public interest in mitigating this sort of thing. It is easy enough for the Federal Reserve to say “The Fed’s job is not to protect investors.” But then whose job is it? The SEC’s? We’ve heard from their (former) leadership: Garbage is Ok as long as it is clearly labeled. Should we really entertain such an extreme laissez-faire position in situations like these? 

But here’s the important point: I am not so sure that what is happening with Tesla, and what has already happened with GameStop, really fit the pattern of a “bubble” as the term is normally understood by investors, however loosely. In short, this is not (I believe) a matter of deranged investor psychology. I think there is something else going on, in both cases, and probably in many similar situations, something that is indeed perfectly rational, although not in the sense that “rational markets” are said to be rational. And if its nature continues to go unrecognized, the policy responses are likely to misfire. 

That will be the subject of the next column.



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