Financial bubbles have this disconcerting tendency to pop, bringing misery to millions. These days, people spy all kinds of bubbles, ranging from the stock market to cryptocurrencies to corporate debt.
They’re wrong, though, to think they can detect the next disaster, according to Eugene Fama.
Trying to spot bubbles before they happen is useless, said economist Fama, a Nobel Prize winner known as the father of the efficient market hypothesis. Speaking at the University of Chicago’s Booth School of Business, where he teaches, Fama reasoned that predicting what investment trend will implode isn’t knowable because its weaknesses aren’t measurable.
“People see bubbles where there are none,” Fama told the group, in an appearance that was live-streamed.
To bolster his point, Fama cited a celebrated experiment in a faculty lounge at Stanford. A bunch of professors were presented with charts of agricultural prices. Their charge was to identify any bubbles. The profs did so, and then learned that the data were randomly generated. No patterns existed.
Bubbles are apparent only after the fact, Fama contended. “The way I interpret it is: You must be able to predict the end of it,” he said. “A bubble has to be something with a predictable ending.” And he added: “What’s the testable proposition?”
A man of a decided empirical bent, Fama has demonstrated throughout his career how much isn’t knowable about the stock market. A key part of his efficient market theory is that one can’t know where stocks are headed, because their progress is too often random.
Indeed, trying to detect bubbles before they burst is a daunting, if not impossible, task. Famously, Alan Greenspan, the Federal Reserve’s then-chairman, warned of a stock bubble in late 1996 (“irrational exuberance” had seduced equity investors, he declared). If you listened to him and sold all your stocks, you’d have missed three years-plus of spectacular gains, with the S&P 500 almost doubling.
Yes, there was pain after that with the dot-com bubble’s burst. But who in December 1996 could know how the winds of fortune would blow? For that matter, who in August 2008 knew that the housing bubble was about to burst and almost destroy the world’s economy.
Fama, at least, admits he knows what he doesn’t know.
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Tags: Alan Greenspan, efficient market hypothesis, Eugene Fama, investment bubbles