Blog - Investing Notes

December 21, 2007 - Bubbles: Ride, Watch or Play the Pop?

Should investors who suspect asset pricing bubbles go with it or against? Or, should they just step aside and await a "Return to Normalcy?" In their November 2007 preliminary paper entitled "Riding Bubbles", Nadja Guenster, Erik Kole and Ben Jacobsen investigate empirically the best approach for investors to take regarding active asset bubbles, practically indicated by: (1) a price advance faster than the growth rate of fundamental value; and, (2) a sudden acceleration in price advance. Using monthly returns and contemporaneous fundamentals for 48 value-weighted industry indexes spanning July 1926 to December 2006, they conclude that:

• Bubbles as defined occur at different time horizons than previously researched industry momentum effects.
• Bubbles are reasonably well-spread across the 48 industries, with an average of four bubbles per industry over the sample period. The average raw return of
  industries in bubble mode is about 25% per year.
• Bubbles offer average monthly abnormal returns of 0.41% to 0.64% (depending on risk-adjustment method). The strength and length of a bubble have no effect on returns.
• However, the risk of a crash more than doubles when there is a bubble. The probability of a crash increases with bubble strength, but bubble length does not affect the probability of a crash.
• The reward from riding bubbles on average more than compensates for the elevated risk of a crash, even for investors averse to downside risk. There is no evidence that investors should sell bubbles short.

The following figure, taken from the paper, depicts the monthly count of industry bubbles during July 1971 to December 2006 (as determined from past returns with Fama-French three-factor risk adjustment). While the number of bubbles varies, there are very few months with no bubbles.

The next figure, also from the paper, shows the monthly returns for an out-of-sample strategy of overweighting bubble industries (as identified in the preceding chart) during July 1971 to December 2006. The volatility of these returns demonstrates the riskiness of riding bubbles.

In summary, riding asset bubbles (guided only by information on past returns/fundamentals) is on average an attractive but volatile investing strategy.

Does inverse logic apply to anti-bubbles?

For related research, see Blog Synthesis: Momentum Investing/Trading.