A bubble develops when the price of an asset, such as a stock or commodity, has been advancing for many years. The process culminates with an almost exponential rise that push prices to levels that cannot be sustained by the underlying fundamentals, eventually resulting in exhaustion and the bubble bursting.
It is our intention in this article to take a more clinical approach by quantifying what we mean by a “bubble” solely in terms of market action. In that way, it is possible to compare conditions between individual markets and arrive at a rough standard. There are of course, many other aspects to bubbles and manias, several you can read about here.
MEASURING BUBBLE TYPE CONDITIONS
A key problem is distinguishing a perfectly normal experience, such as a stock or commodity doubling over a five-year period and something that is far more insidious. A good example would be when the S&P grew by a factor of 2.5 in the 10 years separating its 1974 low and 1984 high. Prices seemed a bit heady at the time, but it was no bubble.
One of the required ingredients for a bubble is for prices to inflate slowly and quietly over many years and for this process to cumulate with an exponential type advance. Sentiment plays a huge part, but apart from gut feel, which is not statistically accurate, it is extremely difficult to pin-point the beginning of the unravelling process. That is because there are no long-term indicators that can be consistently applied across multiple markets. Furthermore, when sentiment data is available, it takes the form of short-term polling, rather than information gathered with the purpose of assessing a long-term perspective.
INTRODUCING THE 18-MONTH ROC
A useful approach to the study of bubbles is to include a momentum indicator in the analysis. Momentum is useful because it closely tracks market sentiment. Since it is difficult to quantify long-term investor attitudes directly, the obvious solution is to substitute a momentum series, such as a rate of change indicator.
A useful span that tracks the final exponential rise and exhaustion characterizing the turning point of a bubble is 18 months. The rationale lies in the fact that the 18-month period embraces almost half of the 41-month business cycle, originally discovered by Joseph Kitchen in the 1920s. Recessions have been less prevalent since the 1960s. However, when growth slowdowns are counted along with actual contractions, it can be shown that this cycle has been operating consistently since the early 1960s.