With the recent speculative activity in Bitcoin and GameStop, asset price “bubbles” are once again in the news. While bubbles seem to be becoming more common, I’ll argue that the concept is not very useful, at least for most investors and government regulators.
During the 1930s, many people looked back on the 1929 stock market boom as a bubble. Then in the decades after World War II, bubbles seemed to fade from the public consciousness. In recent decades, surging stock and housing market prices have created new interest in bubbles.
But why do they seem more common today? Many people blame the Fed for creating price bubbles with inflationary monetary policy. But inflation rates for goods and services were much higher during the 1960-90 period, when asset bubbles seemed less common.
The primary factor affecting almost all asset markets is the four-decade-long downward trend in the rate of interest. This decline is not due to monetary policy; rather it reflects deep changes in the global economy, such as higher saving rates, slowing population growth and a shift from heavy industry to services, which all tend to push interest rates lower.
Lower interest rates can impact asset values. Think about mortgage interest rates: When they are low, owning and renting out a housing unit becomes more profitable for any given rental income. This creates a new normal of high price-to-earnings ratios in the stock market, as well as higher price-to-rent ratios in the real estate market. These asset price increases are not necessarily “irrational,” and are indeed consistent with efficient capital markets.
In the housing market, regulations for home building have become much more restrictive during the 21st century. This means that house prices in many coastal areas are no longer linked to the cost of construction. Instead, with a limited supply of buildable land, the price can rise as high as demand warrants. Couple that with low interest rates, and our 20th century assumptions about real estate pricing are simply no longer applicable.
In the equity market, there is now much more uncertainty about the appropriate valuation of many companies, especially in the “winner-take-all” tech sector. Imagine that investors anticipate one-in-100 new high-tech firms becoming the new Amazon, with a rapid 200-fold rise in stock price, and the other 99 completely failing. Should one buy the entire portfolio of all 100 stocks?
Surprisingly, yes. If the information is accurate, this portfolio would double in value, even though all of the gains come from a single stock. And until we know which stock will succeed, this dynamic can inflate the value of each of them.
The example may seem far-fetched, but it’s a bit like what happened to investors who bought the entire tech sector during 2000, when the NASDAQ peaked at roughly 5,000. The index is now close to 14,000, even though many individual companies did poorly. The gains were mostly due to the extreme success of a few companies.
Now consider bubbles from the perspective of the “efficient markets theory” (EMH), which suggests that asset prices reflect all publicly available information, and thus it is almost impossible to know when an asset class is overpriced. Critics of the EMH say the existence of bubbles proves that markets are often irrational, overshooting fundamental values due to “irrational exuberance” by investors. So, who’s right?
It will never be possible to prove that irrational bubbles do not exist. Certainly, there are cases like GameStop that don’t seem to fit the EMH. In that case, a recent short squeeze drove prices to heights that are hard to explain based on the company’s future prospects for earnings. But if we think about the reasons why bubbles seem more prevalent today, it’s not clear that the idea of irrational bubbles is useful to investors.
Some investors will make money by shorting GameStop, but others will lose. Some will avoid losses by refraining from buying tech companies that were overhyped. Others will miss out on gains by refraining from buying stocks like Tesla and Amazon, and cryptocurrencies such as Bitcoin, back when they were already criticized as overpriced, but eventually went on to achieve far higher prices.
The new normal of very low interest rates, restrictive building codes and hard-to-value tech start-ups means one should actually expect to see lots more bubble-like patterns, even if the EMH is true and irrational bubbles don’t exist. Some stock and housing sectors that looked overpriced a few decades ago now seem pretty reasonable in retrospect.
Here’s the lesson: Policymakers should not second-guess asset market bubbles. Instead, they should focus on things they can control, such as using monetary policy to achieve steady and moderate growth in aggregate demand and ensuring that banks don’t take socially excessive risks in lending. Let the market set asset prices.
Scott Sumner is the Ralph G. Hawtrey Chair of Monetary Policy with the Mercatus Center at George Mason University and a professor emeritus at Bentley University.