If a Tree Falls in the Forest

We all know the existential question: if a tree falls in the forest and there’s no one there to hear it, does it make a sound?  While you contemplate how you might personally respond to such a query, here’s a follow up: if a stock market bubble gets bigger and bigger, but doesn’t pop, is (was?) it really a bubble?

In 2013, two of my personal heroes, Eugene Fama and Robert Shiller, shared the Nobel Prize in Economics with Lars Peter Hansen for their contribution to our understanding of asset pricing.  The folks on the selection committee in Stockholm were a bit devious in recognizing them concurrently, because they have diametrically opposed views on the subject.  One might say that Fama’s view is ‘micro’ in perspective and revolves around the efficiency of prices for individual securities, while Shiller’s view is more ‘macro’ in nature since it focuses more on overall market valuations and group behaviour.  At first blush, these paradigms seem irreconcilable.  How can prices be more or less fair and wildly out of whack simultaneously?

Think of Shiller‘s perspective this way: it’s a bit like children at a water park standing under a big bucket suspended overhead that is filling up slowly before it suddenly tips over and sends a torrent of water spilling down on those assembled below.  At the water park, one can reliably expect the big bucket to tip over every 4 or 5 minutes.  That’s where the analogy ends.  Although markets routinely take tumbles of varying degrees (there was a ‘correction’ of about 10% at the end of the summer of 2020, for instance), the timing, duration and degree of those tumbles is difficult (read: essentially impossible) to predict.  In 2010, in the aftermath of the global financial crisis, Fama did an interview with the New Yorker magazine in which he said:

Now after the fact, you always find people who say that before the fact, prices are too high.  People are always saying that prices are too high.  When they turn out to be right, we anoint them.  When they turn out to be wrong, we ignore them.  They are typically right and wrong about half the time.

Fama has suggested that it’s easy to point to something ‘being in a bubble’ after the fact, but since there’s no reliable way before a bubble bursts to determine:

  1. Whether or not we’re in a bubble; and
  2. If so, when it will burst; and
  3. If so, how severe the market drop will be; and
  4. If so, how much time needs to elapse before we hit a bottom and resume an upward climb

I understand Fama’s frustration, given how liberally people use the word ‘bubble’ after things drop, yet seldom use similar terminology immediately prior to that drop.  It’s understandable.  The behavioural question for investors might well be: accepting the unpredictability that Fama notes, what are we to do as rational, self-interested decision-makers?   Here’s where I want to apply Annie Duke’s (see Bullshift Culprit #3 : Resulting) thinking to Fama’s commentary.  We should all be mindful of “resulting”.  Fama is right from the media’s often oversimplified perspective. Too often, people are heroes when things work out and nobodies when they don’t.  Instead of judging the ‘market is high’ crowd as either brilliant prophets or hapless Chicken Littles, perhaps we could be more nuanced and acknowledge that these people are simply making an independent assessment of how things might unfold in an uncertain world and are proceeding accordingly.  People make decisions to the best of their abilities with the information they have.  Sometimes a diamond.  Sometimes a stone.

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