Not Fully Inflated

Many investments are becoming expensive. But there is little sign of the mania that accompanies most bubbles.

Talk of bubbles is in the air again. The Dow Jones Industrial Average has hit an all-time high. A loss-making technology firm (Twitter) has floated its shares on a flood of investor demand. Private-equity groups are buying companies using amounts of debt not seen since 2008. A record price (more than $50 million) has just been set for a penthouse in Manhattan. A triptych by Francis Bacon became the most expensive piece of art sold at an auction when Christie’s flogged it for $142.4 million last month. Robert Shiller of Yale University, who correctly identified bubbles in tech stocks in the late 1990s and in property in the 2000s, has expressed unease about giddy American share valuations.

All this suggests that wealthy investors have become increasingly confident. The question is whether they are right to be. Under certain circumstances, fast-rising asset prices are justified. New industries can emerge and create corporate giants (Microsoft, Apple and Google, for example); countries can change their economic policy and grow rapidly (Japan in the 1960s, China in the 1990s). How, then, do you tell a bull market from a bubble?

Mr. Shiller describes a bubble as “a psycho-economic phenomenon. It’s like a mental illness. It is marked by excessive enthusiasm, participation of the news media and feelings of regret among people who weren’t in the bubble.” They are often enlarged by an expansion of credit. But establishing an objective definition is hard. For GMO, a fund-management group, a bubble is an increase in the price of an asset of more than two standard deviations above the trend, taking inflation into account.

Financial bubbles graphicUsing that standard, GMO has identified 330 bubbles between 1720 and 2010. They have become much more frequent in recent decades (see chart). That is partly due to there being more markets to analyze these days. But it is probably also a reflection of the explosion in global capital flows that followed the collapse of the Bretton Woods system of fixed exchange rates in the early 1970s. It is hardly surprising to find that more bubbles have been inflated as investors have rushed round the globe in search of the next big thing.

Many economists have struggled to accept that bubbles exist, as that is difficult to square with the idea of efficient markets. If assets are obviously overpriced, why don’t smart investors take advantage and sell? Edward Chancellor of GMO argues that investors can find it hard to arbitrage away a bubble. Manias can last much longer than investors think, as many contrarians discovered to their cost during the dotcom boom of the late 1990s. Nor do investors know whether a bubble will be resolved through a sharp fall in prices or a long period of stasis, in which inflation erodes prices in real terms (something that happened to British houses in the 1970s).

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