Bubble Identification
December 30th, 2007 by 
reality
How does one identify a bubble in asset prices? It is simple. When the investment return on the asset is less than the carrying cost, then the only reason for the asset prices is speculation.
For example, when rental income will not pay the carrying cost of a house, then the price of the house is driven by speculation. Either the buyer is expecting a financial benefit from appreciation, or believes that the price will rise in the future so that buying now is prudent. In either case, the buyer is a speculator. If the buyer just wanted a place to live, then renting would be the logical and economic choice. But we all know, by now, that residential real estate is in a bubble.
But what others are out there?
- Commercial real estate. Less publicized, but not so visible, commercial properties have been selling at cap rates in the 1.5% to 4.5% range. In many cases, the negative spread between net rents and borrowing costs is even higher than residential properties.
- Shares. Not all, of course, because earnings and dividend yields are all over the map. Even being aggressive and using earnings rather than dividends, not many people or funds can borrow at less than the S&P 500 earnings yield of 5.3%. And many tech stocks, in particular, have earnings yields in the 1-2% range, indicating a high degree of speculation.
- Government bonds. With LIBOR at around 4 3/4%, you can’t borrow to fund a 4 1/2% yield on 30-year Treasuries.
And so on. Of course, you will point out that those of us who have the privilege of borrowing Mr. Fukui’s cheap yen can ignore all these nasty rates. But then there is a new risk, the forex risk, which has to be carried somewhere, and the rising yuan is sending a message about the future of the yen.
Posted in Fixed Income, Manias, Real Estate, Saving & Investment, Stocks, Strategy & Scenarios | 
December 30th, 2007 at 11:36 pm
You need to take into account potential growth of earnings and rents over time.
December 31st, 2007 at 4:14 am
That’s what bubbleonians tell themselves to rationalize their actions.
Bubble psychology is that prices always go up. But the rent/purchase imbalance is like a commodity selling below the cost of production - there is an unsustainable imbalance and it is a matter for speculation how it will be resolved.
December 31st, 2007 at 11:10 am
I believe that language and its use is very important. Your definition of a bubble is far to broad in my opinion. According to your definition, anything that is above the carrying cost is in a bubble. Based on that argument, what would be left to buy for investment other than utterly depressed assets? While I am not a practitioner, there are many very successful growth managers who would take issue with your classification. Was buying Microsoft in 1991 when it was “expensive” buying a bubble?
I think a much better definition is the nexus of easy credit fueling as dramatic mis allocation of resources in a sector or an economy. There are always areas of speculation, excess and momentum and I believe that calling all of these “bubbles” dilutes and devalues the seriousness of what a real bubble is. The current excesses in the solar stocks is a good example - are these stocks likely to suffer a violent collapse at some point? Probably. Is it a bubble? I would argue no - just the typical manic behavior of the mob.
December 31st, 2007 at 11:57 am
Buying Microsoft may have been a successful speculation, but it wasn’t a good investment. It was pumped up in the tech bubble, which still isn’t over.
It is possible to make a great deal of money in bubbles, but they’re a trade. Like the solar stocks you mention. You have to know when to get out. Jeremy Grantham’s research, which found 28 bubbles, used the definition of a 2 sigma deviation from trend. That’s a lot of bubbles. A bubble is a typical manic behaviour of the mob, it is just that some are bigger than others and cause bigger disasters when they burst. I don’t think your definition would disqualify any of the bubble candidates that I listed.
Best wishes for 2008.
December 31st, 2007 at 5:31 pm
Thank you for the thoughtful response. I guess we can agree to disagree! I think your response highlights your loose use of language. At first bubbles are easy to spot as they are comprised by anything that is valued above the cost of carry. Then, you site Mr. Grantham and GMO’s work, which I actually agree with. I can assure you that 2 standard deviations above mean is WAY above carrying cost.
Your comment regarding Miscrosoft assumes that the market is perfectly efficient. I would be surprised if you believe that, as that would directly contradict the existence of bubbles! It is a reality that some companies are undervalued, even at high “current” multiples or compared to carrying costs, as the marekt is not efficiently pricing in all future potential growth. Microsoft was reasonably valued for a growth stock and multiplied multiple times before the tech bubble formed post 1997 and it was due to monopolistic earnings growth. Many of the great growth stocks in history compounded at high rates for extremely long periods of time (starbucks, dell, etc). Sure, as some say, there are only two kinds of companies - those with problems and those that will have problems. All growth stocks eventually crap out, but to call something like starbucks a bubble for the past 15 years is a bit ridiculous in my opinion.
Thanks for the good wishes and right back at you - and keep up the great work with the blog.