The FT’s “year in a word” series suggested that the spirit of 2013 could be captured in words like “taper”, “sequestration”, “Abenomics”, “selfie” and, of course, “twerking”. I would like to suggest another over-used word from last year: “bubble”. In fact, there was a bubble in the use of the word bubble, especially relating to the S&P 500 index.
It is not very helpful simply to throw the term bubble at any situation in which market prices are deemed to be rising too fast. We should try to do better than that. Many investors would like to be able to distinguish bubbles, which happen relatively infrequently, and tend to reverse extremely abruptly, from a regular bull market.
Accordingly, this blog presents a new research paper released yesterday by my Fulcrum colleagues Ziad Daoud and Juan Antolin Diaz (available here) that attempts to define and measure a market bubble more precisely. It uses new econometric techniques developed by Peter Phillips and others, and updates their results to the present.
One important conclusion is that the probability that the S&P 500 index is currently in a bubble is only 20-33 per cent. But that could change fairly quickly during 2014 if the recent pace of advance in equity prices continues. And, just to be clear, this conclusion does not mean that normal market corrections, or a regular bear market, cannot happen this year. Bubble detection may be one metric to aid market forecasting, but it is far from the whole story. Read more