Bubble vs no bubble?

Bubble vs no bubble?

We were interested recently to see Jeremy Grantham add his view to the “bubble or no bubble” debate. In a typically thoughtful contribution, Jeremy has set out a test for what constitutes a bubble and determined objectively that equity valuations currently do not meet that test.

We note however, that Jeremy has set the hurdle pretty high in defining a bubble (2 standard deviations from the average). A market which is 1.4 standard deviations above the average valuation might not qualify as a bubble, but is still well above fair value. Referring to our basic statistical tables suggests that equities ought to be cheaper than this in around nine out of every ten years.

See below for an extract, or view the full article on Barron’s.

“There are two good standards for a bubble. One is boring statistics, and the other is an exciting behavioral frenzy, on which so many good books have been written. And based on the boring statistics, the data is really very clear: We are not even that close to a bubble. With the S&P 500 at around 1860 recently, we are at about a 1.4- to 1.5-sigma event. Another way to say that is that we are between one and two standard deviations outside the normal distribution of stock-valuation levels. A two-sigma event would put the S&P 500 at 2350. So using the standard definition, it has to go up another 30% from here to get to a bubble. But you don’t know when an ordinary market move is a bubble; you only know that in hindsight. As for the second test, which is euphoria, I like to joke that in 2000 here in Boston, Celtics replays were displaced at lunchtime at the greasy spoons by talking heads on TV. You would go to one, and they would be touting the latest Internet stock. But I’ve noticed recently that they are still playing the sports highlights on the televisions in the pubs here.”