A common misconception I have found when I speak to others about economic crashes is the idea that no one knows when a market is experiencing a bubble, as after all, if everyone knew we were in a bubble the market would immediately correct itself. This is not necessarily true; even in 2008, many famous economists, like Nobel Laureate Robert Shiller, identified the bubble in the housing market far before it burst. In April 1999, 72% of investors knew they were in a bubble, yet it did not burst until 2001.

This statement immediately leads to “well surely they just shorted the bubble, and they made loads of money”, with a reference to The Big Short to back up their point. In real life, it isn’t that easy, and bubbles can sustain themselves for a very long time. 

The first obstacle of shorting a bubble is determining when you think the bubble will burst- as Keynes said “markets can remain irrational longer than you can remain solvent”. Nate Silver in his book “The Signal and the Noise” delved deeper into this concept. A key way to identify a bubble is to look at the Price to Earnings ratios of stocks. Historically, P/E ratios for the S&P 500 have hovered around 13-15, with this being considered a rational, fair valuation of the stock. During bubbles, these ratios can reach far higher- in April 2000, just before the .com bubble burst the S&P 500 P/E ratio stood at 29. So one can assume that a P/E ratio of 30 or above means a crash is imminent? Not necessarily. Alan Greenspan used the infamous words “Irrational Exuberance” to describe the stock market in December 1996, when the P/E ratio was 28, yet the peak of the bubble was still more than 3 years away. 

Silver found that even if P/E ratios stood at 30+, the chance of a crash over the next year was only 19%, with the chance being 12% for 25-30 and 10% for 20-25. This means if you are shorting stocks, you could have to hold these stocks for multiple years in order to finally see your rewards. If the market increases in value at any point during these years, you lose money, bankrupting you before you are able to reap the rewards of your foresight.

The Big Short drastically simplifies the process of shorting a stock. The person loaning you the stock can demand them back at any time, allowing them to quit whilst they are ahead. You are also charged an interest rate for the privilege to short. Sometimes, you are unable to short the stock at all, as the stockholders may also see the crash coming and therefore be unwilling to lend the stock, unless at immensely high premiums. Some countries don’t even allow short selling to take place. 

In order to short, you must also have a good idea of the correct value of the stock, and therefore the difference between its current irrational value and its correct value. Yet calculating such a value requires knowledge impossible to attain; uncertainty increases exponentially as you look further and further into the future, and the current value of the stock is essentially a prediction of the value of the stock thousands of years into the future. The thinking behind the accurate valuation of stocks, or lack thereof, would require a separate article of itself, yet it is important to consider when talking about bubbles. Contradicting common neo-classical thought, many investors in equities do little stock analysis themselves, and instead free ride off of the “experts” by just looking at the movement of stocks. However, when everyone believes that everyone else are experts conducting actual analysis, experts whom they can just free ride off of whilst doing no actual analysis themselves, you are left with a market where no one has any idea of the real value of the stocks they are buying, and so identifying just how much the stock is overvalued is impossible for most. Anchoring becomes important here. If you are an investor with no real idea what the stock should be worth, you are going to base your idea of a fair valuation by any metric available, this metric commonly being their current price or the price of similar stocks. Therefore, even though many will realise they are in a bubble, identifying the true value of the stock is almost impossible and so the safest option is to assume the current price is correct, as that is the most convenient value to work off of. 

Moreover, most stocks are not held by individuals nowadays- by 2007, 68% of stocks were held by firms, not individuals, causing a conflict of interest. Game theory is all that is needed to realise why workers for trading firms would not start shorting stocks even if they saw a crash coming. If the trader believes the market is about to crash, and so they start to sell stocks, 1 of 2 scenarios can happen: 1) If the market does indeed crash, the trader looks like a genius, yet is not rewarded with too large a bonus as the market has just crashed so firms can’t afford to be so cavalier with their money. 2) If the market does not crash, the much more likely scenario, not only has the trader lost large sums of money for the firm but he has stuck his neck out from the herd and got it wrong, leaving him likely to find himself unemployed in the near future.  

If the trader plays it safe and continues buying stocks one of two scenarios can happen: If the market rises, as it is likely to do, it is business as usual and he gets a nice bonus. If the market crashes, yes he loses the firm money, yet as he has stuck with the herd he cannot be blamed for such a decision, and so we will keep his job. 

As shown from these scenarios, playing it safe and buying stocks, even if you believe a crash is coming, it the smart decision to make when working for a firm. This can be seen as an extension of the principal agent problem; the person who is controlling the buying and selling of the stocks is not the one who directly benefits from the correct decisions being made, and so the incentive for the trader, rather than to maximise the value of the portfolio, is to guarantee the safety of their job. 

This is altogether ignoring the fact that it benefits many for the bubble to continue. Few gain from a stock market crash, yet many do from a rise in stock prices. Many investors may even be encouraged to enter the stock market if they hear it is experiencing a bubble- they too will want the large amounts of money being generated from the inflated prices, an action which only increases the bubble. Therefore, telling the market that they are in a bubble simply isn’t enough – this may even encourage the bubble to grow as more will enter the market to take advantage of it. Many traders, and even sometimes central banks (see the Bank of Japan buying stocks), will work hard to keep the bubble going to continue enjoying the benefits. This translates to bubbles in other asset markets as well.  

Why did the ratings agencies, who had the best information of all on the probability of defaults on mortgages, not lower the ratings they were giving to Collateralised Debt Obligations sooner? The truth is these agencies were making huge sums from the bubble- Moody’s (the bond credit rating agency) profits rose more than 800% from 1997 to 2007. Lowering ratings would damage this bubble, and by extension their profits. 

The knowledge that we are in a bubble is not the jackpot The Big Short would make it out to be. Shorting has a large number of obstacles which severely limit the profits to be made. Even that is assuming that shorting is in your best interest- predicting the exact moment a market will crash is nearly impossible, and attempting to do so can leave you paying premiums for possible years. 

Caspar Slee