Over the last five years, Americans have watched equity markets soar. Just last month, the S&P 500 reached an all-time high of 6,144, up over 89% from January 2020. Such a precipitous increase in the value of U.S. equities has stirred up the usual cacophony of equity-bears screaming “bubble!”
“Bubble” is a popular term, but, as it turns out, is rather ill-defined and fuzzy. It is supposed to refer to a period in markets when asset prices are above a level justified by their fundamentals. Indeed, many economists have beefs with bubbles. Peter Garber, the author of Famous First Bubbles: The Fundamentals of Early Manias, argues that so-called bubbles are in fact rhetorical weapons used to argue the markets are “crazy” and need to be more severely regulated. Nobelist Eugene Fama, colloquially known as the “father of modern finance,” takes issue with the term “bubble,” too. He argues that, if bubbles did exist in equity markets, then large increases in a stock’s price should predict lower returns going forward, which is usually not the case. Research from Harvard economists Robin Greenwood, Andrei Shleifer, and Yang You lend credence to Fama’s claim, although the authors did find that the nature of a stock-price run-up can help predict a future crash.
