Wouldn’t it be great to determine a bubble as it was happening?
That’s an objectively impossible task, though it hasn’t stopped people from trying to come up with a mathematical framework. An asset going up doesn’t necessarily make a bubble, because sometimes there’s a fundamental reason for that asset going up. Strategists at JPMorgan highlighted a model created in 2000, which fits the price time series of an asset to a logarithmic power law equation.
“The bubble is one in which the fitted parameters point to a faster-than-exponential growth, an increasing number of oscillations (more volatility at the end of the bubble), and a critical time in which growth rate becomes infinite,” the JPMorgan team said.
That sounds great, but for one thing: “We can conclude that the bubble/anti-bubble signals by themselves do not seem to work,” the bank’s quants said. (We’ll spare you the details.)
But the JPMorgan team did some tinkering, adding to this model a moving average, to determine when mean reversion has started. In this way, investors using the framework would not be fighting the market or committing too early. “While the emergence of bubble probabilities should make us more progressively nervous, we can get help from momentum crossover signals to time entries/exits, significantly improving the results,” they said.
This seems to help — the combined model in 2008, for instance, turn short the S&P 500
SPX,
Over a 30-year period, the model minus transaction costs outperforms the S&P 500 by 1.9% per year, the strategists said.
What about now? As of May 24, the team found there are more anti-bubbles than bubbles out there. That said, they found that emerging market equities, U.K. government bonds and emerging market currencies were triggering buy signals — and the U.S. dollar was triggering sell signals. But again, the main takeaway was that there weren’t many bubbles around.
“For the most part, we are not generally seeing strong signals for bubbles in today’s markets, apart from a recent sell-off in bonds in early March that would have met our criteria to get long duration in multiple global bond markets. The poor participation in today’s thinly traded equities rally is indeed a problem that we have flagged, but it is not captured by this framework. Given the current unnaturally low volatility despite risks of debt ceiling, regional bank stress, and recession, we anticipate that this framework may become very relevant in the near future,” they said.
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