How Can We Identify Asset Bubbles In Real Time?
Defining investment bubbles
I’ve written a lot about bubbles lately. I looked at how policy makers contribute to their formation in these two pieces: here and here. I also took a look at the housing bubble that’s probably about to get bigger when interest rates decline in the fall.
But I realized I’ve never really written about the definition of a bubble. Partially that’s because it’s subjective — one person’s opportunity is another person’s bubble. So I’ve always taken a “I’ll know one when I see it” approach. But thinking back, I think that’s being intellectually lazy. Yes, it’s important to discuss how bubbles form and the impacts of their eventual bursting — but it’s also important to try to identify them in real time.
The price, demand, expectations feedback loop
In my opinion, the defining trait of a bubble asset is a strong and positive correlation between three things:
- Price
- Demand
- Expectations (a.k.a. hype)
In bubbles, when fundamentals get thrown out the door (because valuations have risen too far beyond what near-term cashflows can justify) and the marginal buyer is probably both leveraged and gambling, price action becomes the…
