Over the past year, Nvidia’s stock has soared by more than 200%, igniting talks of a “bubble” among the self-proclaimed financial seers. But what precisely do we mean by a “bubble”? This term, often thrown around loosely, lacks a consistent definition among its most vocal proponents.
To shed light on this, let’s consider the insights of William Goetzmann, a distinguished figure from the Yale School of Management and a Research Fellow at the National Bureau of Economic Research (NBER). Goetzmann offers a concrete framework to understand market bubbles: a “bubble” involves a spectacular surge in prices, a “boom,” by at least 100% within a year, followed by a precipitous drop, a “crash,” of 50% or more in the subsequent year. This phenomenon is analyzed at the level of country indices, not individual stocks or small groups thereof.
Goetzmann’s comprehensive study of over 3,000 annual stock returns reveals that true bubbles are a rarity, occurring in just 0.3% of cases. Moreover, a market that has doubled in value within a year has a mere 4% chance of halving in the following year. Conversely, there’s an 8% chance that such a market will double again. This finding challenges the common narrative, highlighting that the market’s potential for growth often outweighs the risk of a significant downturn.
The narrative around bubbles is further complicated by the media’s penchant for amplifying doomsday predictions, often without accountability for the prognosticators’ track record. Goetzmann extends his analysis to a five-year horizon, where the likelihood of a bubble forming increases but remains statistically small. After a market rises by 100% within a year, there’s a 15% chance it will halve in the next five years, compared to a 26% chance it will rally by another 100%.
These statistics urge caution in the rapid labeling of market conditions as “bubbles.” While true bubbles leave a lasting impact on the market and investor sentiment, their actual occurrence is much less frequent than commonly perceived.
In reflecting on today’s market dynamics, even considering the notable growth of leading tech stocks, we find ourselves far from the speculative extremes that define real bubbles. This perspective, grounded in historical analysis and statistical evidence, provides a necessary counterbalance to the often sensationalist bubble discourse.
Source: Goetzmann, William N., Bubble Investing: Learning from History (January 11, 2016). Available at SSRN.
Jeroen Blokland, with his extensive background in multi-asset investment and founder of True Insights, brings this nuanced understanding of market bubbles to our readers weekly. Blokland’s expertise, honed through years at the helm of multi-asset strategies at Robeco, offers a grounded viewpoint on the complex dynamics of market speculation and investor behavior.