I say this is not because I don’t think the stock is overvalued. I do, as I outlined last week. But according to the only statistical model I know that predicts the probability of a collision, the chance of a bubble bursting in the coming months is low.
That hasn’t stopped many commentators from asserting that the market is in a bubble about to explode. In fact, according to Google Trends, web searches of the recent “stock market bubble” have reached their highest level since at least 2004, which is how expansive historical data is. Jeremy Grantham, co-founder and chief investment strategist at Grantham, Mayo, & van Otterloo (GMO), recently predicted that the market is in a bubble that will burst for months, not a few. week.
The statistical model that I am referring to is the evolution of a study that appeared in the Journal of Economics and Finance. Its authors are Robin Greenwood, a finance and banking professor at Harvard Business School and chair of the Behavioral Finance and Financial Stability project; Andrei Shleifer, Harvard economics professor; and Yang You, a Ph.D. economic candidate at that school.
The researchers, focusing on sectors and fields, define a bubble burst as losses of at least 40% over a two-year period. They found that the odds of this happening were 50% whenever the industry in the previous two years beat the overall market by 100 percentage points. As you can see from this chart, this odds went up 80% whenever the profits beat the market as high as 150 percentage points. And when the market-adjusted returns for two years are much higher than that, collapse becomes “almost certain”.
By the standards of this model, no industry group in the US market is currently approaching. Among the 11 major industries in the S&P 500 SPX index,
for example, the best performing in the past two years was the technology sector SPDR ETF XLK,
But it beat the S&P 500 “just” by 41 percentage points, according to FactSet. According to the researchers’ model, this performance was not related to a significantly higher probability of a collision.
This does not mean that the technology sector cannot collapse. But if you think it does, you’ll have to base your forecast on something different than its recent performance.
What about individual stocks? Researchers do not focus on them. But I still place each FANMAG on their model, as those stocks are usually Chart A in any argument about a top heavy market that is prone to crash. Of course, these shares are Facebook FB,
and Google GOOG Parent Alphabet,
According to FactSet, they currently account for 20.7% of S&P’s market cap.
Of these six, the one with the best performance in two years is Apple, and it has beaten the market in the past two years by 80 percentage points. Although two-year returns are associated with a slightly higher probability of an accident, the researchers calculated that odds to be modest. Analyzing all the industries since 1926 that have beaten the market with this money over a two-year period, they find that on average they continued to beat the market 3% over the next 12 months.
What about Tesla TSLA,
? It certainly meets the researchers’ criteria, as its performance margin compared to the S&P 500 has been a staggering 461 percentage points over the past two years. That said “it is almost certain that in the next two years it will drop at least 40%.
As for the profile, I should admit that I made a similar prediction about Tesla last year, based on the researchers’ model. The first time, in early February, turned out to come true after just six weeks: It fell 60% from February’s high to March’s low.
My second article about Tesla is still not successful. That column was published in early July, and the stock is 34% higher now than it was then. But note that the jury still had a lot of guesswork left for that July, as it had a two-year time frame.
Why eagerly declare that a bubble is forming?
Another related finding is that bubbles are very rare. From 1926 to 2012, only 40 industries beat the market 100 percentage points in any two-year period. And out of those 40, only 21 actually exploded. So, on average, one bubble is established every 26 months and one real bubble bursts on average every 49 months.
What about the bear market that caused the pandemic last February and March? Were there any industry losses that were considered a bubble burst?
No, at least not according to researchers’ criteria: The best performance of any of the S&P 500’s major industries two years prior to February’s market high was again the Technology Select ETF. Sector. It beat the S&P 500 in that two-year period by 29 percentage points.
Obviously, bubble predictions are much more common than actual bubbles.
Why are you eager to spot bubbles? Will Goetzmann, a finance professor at Yale University, told me he doubts it has to do with the public morals that analysts associate with bubbles. When they claim that we are in a bubble, they are going beyond their forecasts of an imminent bear market and implying that big losers will get what they deserve.
I suspect that the temptation to apply this ethical rhetoric will be especially strong for those who have been bearish for several years now and have thus missed out on the dramatic stock market rally. Grantham falls for this discount, and I can sympathize. Most of the long-term indicators have been down for several years now.
However, there is no research or data to guarantee the market will not collapse. But as with any aspect of stock market forecasting, it is important to determine exactly what we mean when a bubble burst and then incorporate that definition into historical research. And the current market doesn’t meet the plausible definition used by the Harvard researchers.
The bottom line? There are probably more pressing issues to worry about than whether this latest bubble prediction will be successful.
Read it now:Next bear market will be worst in at least 78 years, warns co-founder of Soros’s legendary Quantum Fund
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a fixed fee to be audited. He can be contacted at firstname.lastname@example.org.