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"Bubble, bubble, toil, and trouble..."
When does an increase in asset prices turn into a witches' brew? Scarred by the brutal bursting of the Nasdaq bubble last spring, there is a growing fear that the boom in the housing market is another bubble. Some even worry that the popularity of small-cap stocks signals a bubble in the making. But the term "bubble," perhaps the most menacing word in finance, is being tossed around far too easily these days.
Let's not forget that small bubbles in asset pricing are forming and popping all the time. As a matter of course, prices stray from fundamental value, and no one is ever really sure whether a stock or a home is undervalued or overvalued. The late Fisher Black, one of the so-called "rocket scientists" at Goldman Sachs and best known for his work on pricing options, once defined a well-working market as one in which price is within a factor of two of value.
Let's assume the fundamental value of IBM is equal to its current market price of around $104 a share. Even then, given all the uncertainty surrounding corporate earnings, new product development, economic activity, and competitive threats, investors could reasonably price IBM as high as $208 and as low as $52, according to Black's theory. "The factor of two is arbitrary, of course," wrote Black. "Intuitively, it seems reasonable to me, in light of sources of uncertainty about value and the strength of the forces tending to cause price to return to value."
POST-POP HARDSHIP. So when does a bubble become dangerous? When, much like a Ponzi scheme, it vastly diverges from the ebb and flow of prices. For instance, asset prices rose tenfold within a relatively short period of time during the infamous South Sea and Mississippi bubbles of the 18th century, when the English and French governments, respectively, tried to refinance war debts by issuing huge numbers of bonds. In each case, a company acquired government debt, expanded through corporate takeovers, and sold shares to an eager public. Speculative fever took hold. Soon, there was far too much debt for much too little profit. "A [dangerous] bubble is characterized by a price that is immensely out of line," says Peter M. Garber, global strategist at Deutsche Bank and author of Famous First Bubbles (2000, MIT Press).
The essence of a bubble is a dramatic price increase that stokes a speculative frenzy. A mass mania emerges as soaring prices and investor enthusiasm feed off one another until reality unexpectedly inserts its pin. Pop! The bubble bursts.
Bubbles are among economic history's most fascinating -- and frightening -- phenomena because pricked bubbles can end in economic hardship, from Tulipmania in 17th century Holland to the Roaring Twenties and the Great Depression to the popping of the Internet bubble linked with the current slowdown. "The dynamics of a bubble are people taking leave their senses and believing that fundamental values don't matter anymore and that the 'greater fool' theory takes hold," says Meir Statman, finance professor at Santa Clara University.
Nevertheless, there is a great deal of mythmaking when it comes to bubbles. In Famous First Bubbles, Garber carefully documents how many stories of investor foolishness and irrationality concerning Tulipmania, and the South Sea Bubble and Mississippi bubbles are really myths. For instance, the Dutch dominated the market for tulips in the mid-17th century. A shift in French fashion sparked a sudden surge in demand for beautiful and rare varieties that resulted from a poorly understood tulip virus. That's a bizarre twist on supply and demand.
NOT SO FOOLISH. Yes, investors do get carried away. But in the aggregate, major market moves largely emerge during times of rapid innovation and technological progress. It becomes increasingly difficult for investors to figure out the direction of corporate profits and other economic fundamentals. They may have bet on the wrong side of history -- but not necessarily in a foolish way.
Which brings us back to today's housing market. The strong pace of house-price appreciation over the past several years has its roots in low mortgage interest rates, a low level of unemployment, the aging of the baby-boom population, and a record wave of immigration rather than in irrational exuberance. "It's hard to see any huge mania in housing," says V.V. Chari, finance professor at the University of Minnesota. "You can't call the national housing market a bubble."
To be sure, if the economy sinks into recession and unemployment rises, the housing market will turn down. But that's far cry from the ominous "pop" of a big bubble burst.
Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over National Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BW Online Edited by Douglas Harbrecht
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