Market Matters for August 26, 2014
Below is a weekly update from our Chief Investment Officer, Dr. Scott Lummer. He co-hosts an audio segment entitled “Market Matters.” In this week's show, Scott discusses market bubbles. He explains the three factors that are present for a market bubble, and differentiates between bubbles and investments that simply decline in value. He gives examples of recent bubbles, and states that the current stock market is not a bubble. Each week he covers a different piece of investment news focusing on recent events in the capital markets, and relates them to Savant Investment Group’s perspective on investing.
Daphne: Welcome to Market Matters, a weekly discussion about investing in today’s capital markets. I’m Daphne Feng and, as always, I’m joined by the Chief Investment Officer of Savant Investment Group, Dr. Scott Lummer. Scott, I’ve been hearing a lot about market bubbles lately. What precisely is a bubble?
Scott: A bubble occurs when the price of something is bid up by investors to an amount that is higher than can be justified by any rational analysis. At some point, investors as a group realize that the investment is overpriced, and the bubble pops, resulting in catastrophic losses in value for those who bought at the top of the market.
Daphne: Is that like the real estate market of the last decade.
Scott: Yes, I would say that real estate, particularly in some states like Nevada and Florida, was a bubble. It was difficult to justify the prices of those properties through fundamental analysis
Daphne: Does that mean every time an investment declines a lot in value, it was because it was a bubble?
Scott: Some people view it that way, but I don’t. Sometimes an investment is prudently evaluated, but the rational assumptions that justified its price didn’t work out?
Daphne: You sound like you’re splitting hairs. What’s the difference between a bubble and an investment that is rationally priced but falls in value?
Scott: I would say there are three factors that constitute a bubble. First, there is what’s missing – a rational analysis that justifies the investment’s value. Second, the main justification for the price is simply the trend of recent prices. That is what happened with real estate in the mid-2000s. The justification that one should buy properties was the fact that prices had recently gone up a lot in value – which, when you think about it, is counter-intuitive. Third, most of the buyers tend to be speculators who are relatively new to the market, as opposed to long-term investors. Again, that happened in the real estate market.
Daphne: What about the stock market of 2008. Values dropped on average by more than 50%. Was that a bubble?
Scott: I would say no. While there is a lot of revisionist history, there was little consideration in early 2008 that there would be an extreme financial crisis. The values of stocks early in that year were supported by high earnings levels and expected continued economic growth. While stocks had performed well during the years leading up to 2008, that was not the justification used by most investors for buying stocks. And while some speculators were investing in stocks, most investors were the same types of entities who have always invested in the market – pensions, endowments, foundations, and long-term individual investors.
Daphne: Have there been other bubbles recently besides real estate?
Scott: The gold market around 2010-11 was a bubble. After listening to the promoters of gold during that time, I felt like I needed to take a shower. I would also suggest the market for tech stocks in the late 1990s was a bubble.
Daphne: Are bubbles a recent phenomenon?
Scott: No, there have been bubbles as long as there have been markets. One of the more well-known early bubbles was the Dutch tulip bulb craze of the mid 17th century. Values of bulbs got bid up to ridiculously high prices – a single bulb could be exchanged for 12 acres of land. When the bubble popped, values fell by over 90% in a couple of months.
Daphne: Would you say the current stock market is a bubble?
Scott: No – while there can be debate about what the true value of the current stock market is, it is definitely not a bubble.
Daphne: Can you give me a SHORT answer about why.
Scott: Not a short answer – there are many reasons. To start -
Daphne: Sorry Scott, we’re out of time. So that’s Market Matters for this week. Thanks to all of you for listening. Please join us next week when Scott and I will talk specifically about why the current stock market is not a bubble.