It is likely that
S&P 500 Technology Hardware, Storage & Peripherals index
is in a bubble at risk of bursting.
That’s the conclusion I draw from a study by three Harvard University researchers: Robin Greenwood, a professor of economics and banking who chairs the institution’s project on behavioral finance and financial stability; Andrei Shleifer, an economics professor; and Yang You, a Ph.D. candidate. In their study “Bubbles for Fama,” published in the January 2019 issue of the Journal of Financial Economics, they analyzed U.S. stock market history back to 1926 in search of ways to predict a bubble that was about to burst.
Using the formula that the researchers deduce, I calculate that there is an 80% chance that the Technology Hardware, Storage & Peripherals index will be 40% lower than today at some point in the next two years. Among some of the better known companies in this industry are
While no other industry satisfies scientists’ definition of a bubble, two others come close. They are also in the technology arena: Semiconductors and semiconductor equipment and software.
Why focus on an industry that may be in a bubble, rather than the market as a whole? Prof. Greenwood told Barrons that he and his fellow researchers learned from their study of the history of bubbles that they are “rarely market-wide” events. Far more common, he said, is that a bubble manifests itself in certain pockets of the market, though other sectors remain undervalued.
This was certainly the case at the top dot-com-bubbles, mother of all bubbles. Greenwood reminds us that although dot-com stocks rose to outrageous valuations in the late 1990s and early 2000s, other sectors were on the market –especially securities—Was either quite appreciated or even underestimated. Some of the other sectors actually gained ground during the bear market that followed the eruption of the dot-com bubble stock.
Researchers define a bubble as any industry whose two-year return is at least 100 percentage points greater than the overall market. This is actually a high standard – among all industries where they had performance data for between 1926 and 2016, only 40 met the definition at any one time during this 90-year period.
Not all bubbles burst, of course, and those that do burst do not always burst immediately. The researchers also made a strict assumption here: When an industry met their definition of a bubble, they thought it would burst if it lost at least 40% of its value within the next two years. Of the 40 industries that satisfied researchers’ definition of a bubble, 21 – or 53% – were bursts.
What this means, provided the future is like the past: There is a slightly better chance than one in two that any industry that surpasses the market by 100 percentage points over a two-year period will lose 40% or more in the following two years .
The researchers also examined how the probability of a crash changed as they tightened or loosened their definition of a bubble. When they set the criterion to be only 50 percentage points ahead of the market instead of 100, the odds of a crash dropped to only 20%. As they tightened the criterion to 150 percentage points, the probability of a crash increased to 80%.
This latter probability is what applies to the Technology Hardware, Storage & Peripherals index. Over the past two years, according to FactSet, it has surpassed
by 151 percentage points.
One is tempted to apply the professors’ formula to individual securities, as I myself have done in the past. In November 2017, for example, I used the formula to argue for it the odds of Bitcoin going down was greater than 80%. It lost 67% over the next 12 months. I used the professors’ formula once again in February 2020 to claim that the odds of
(TSLA) crash was 80%. The stock lost 59% over the next six weeks.
Since then, of course, Tesla and Bitcoin is skyrocketing, as is the case with a number of other high-flying assets. Should I once again predict that there is a high probability that they will go down, I asked Greenwood? He declared himself hurt and stressed that further research is needed into the various factors affecting the odds of a single stock going down.
Still, he added that he believes not only is the broad stock market overvalued, but there are individual pockets in the market that are “incredibly frothy and bubbly.”
Mark Hulbert is a regular contributor to Barron’s. Hans Hulbert Ratings tracks investment newsletters that pay a fixed fee to be audited. He can be reached at [email protected]
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