A price run-up does not mean a market crash is coming, but there are other indicators that might.
Price bubbles in markets and industries are notoriously hard to spot -- after the fact, they seem obvious, but ahead of time, not so much. New research from Harvard academics seeks to identify factors that might indicate a crash is on the horizon. While a dramatic increase in prices doesn't tell a definitive story, there are other ways to gauge whether we might be in for a crash-and-burn.
Researchers examined dozens of crashes in specific industries (e.g., the dot-com bubble) to decipher what predictive measures, if any, could identify potential bubbles. They set out to evaluate claims by Eugene Fama, a 2013 Nobel laureate recognized as the "father of modern finance," who has long held that stock prices don't exhibit price bubbles at all.
"I think most bubbles are twenty-twenty hindsight," Fama said in a 2010 interview with the New Yorker. "Now after the fact you always find people who said before the fact that 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."
Dramatic increases in pricing don't mean much in terms of future returns, researchers found. Owning something that's gone up in price a lot is, obviously, risky—there's about a 50/50 chance it will end in a big crash.
"On average, returns aren't great following a massive run-up, but they're not terrible either," said Robin Greenwood, professor of finance and banking at Harvard Business School and one of the paper's authors.
Researchers instead identified a handful of other factors that might be more telling for those looking to figure out whether their investments will continue to go up or are headed south.
"You can't predict solely on a price run-up, but once you allow to look at other things, you can," Greenwood said.
So what precipitates a crash? It's not just price—it's speculation, volatility, stock issuance, accelerated price increases and a disproportionate rise in prices among newer firms.
Across 40 cases in the U.S. where stock prices of an industry have increased over 100% in a two-year period since 1928 and international sectors from 1987 to 2013, researchers found a number of common characteristics among those that crashed.
Industries were dominated by younger firms, and there was significant volatility in individual stocks. There was also a lot of issuance—firms issuing new stock or going public—and price increases were accelerated, meaning they went up at an even faster rate than the six months before.
Greenwood pointed to the 1920s market crash and 1990s dot-com bubble as examples. In the '20s, the stock market overall was doing very well, but it was really dominated by a couple of industries, especially utilities. The '90s saw tech stocks soar. Both instances exhibited a number of the above-mentioned characteristics.
"The United States essentially became electrified during the 1920s, and the electricity industry was much like dot-com was in the 1990s, there was an enormous amount of excitement," he said.
President Trump, before arriving at the Oval Office, often warned of an impending market crash, in a February 2016 warning the markets are in a "big, fat, juicy bubble." Since arriving at the White House he has changed his tune on the state of the stock market, instead touting it as a measure of his success even though it's well above where it was when he foresaw impending doom.
Greenwood declined to say definitively whether the broader U.S. markets are currently in bubble territory—his research has focused on specific industries, where specific characteristics are more easily identifiable.
"That said, there's other research which would suggest that the overall pricing of the stock market is very high," he added.
Yale economist Robert Shiller in a recent piece in the New York Times noted his CAPE ratio (cyclically adjusted price-earnings ratio), a valuation measure applied to the S&P 500, is at levels only surpassed historically in 1929 and around 2000.
"The current level of CAPE suggests a dim outlook for the American stock market over the next 10 years or so, but it does not tell us for sure nor does it say when to expect a decline," he wrote. "Investors should not let themselves be tempted to bet aggressively on the Trump bull market."