What Is A Bubble?

We’ve seen some rather substantial (staggering, s*****, ?) sales prices reported lately, which led to a conversation in the car today during a property tour:

The answer, of course, depends upon who you ask:

From How to Detect a Market Bubble by Gavyn Davies in the Financial Times on January 17, 2014:

Bubbles trigger fierce controversy among financial economists. Clifford Asness says that one of his “pet peeves? is that “an asset or a security is often declared to be in a bubble when it is more accurate to describe it as ‘expensive’ or possessing a ‘lower than normal expected return.’? Eugene Fama goes further, arguing that the word bubble is inherently meaningless because it implies nothing more than saying that risk appetite has changed. Robert Shiller disagrees, arguing that bubbles are caused by behavioural aberrations that can sometimes be identified in advance (see this blog for more on the Fama vs Shiller debate).

This disagreement among Nobel Prize winners shows that there is no universally accepted definition of a bubble in financial economics, but Justin Fox at the Harvard Business Review, in a perceptive post, supports the following New Palgrave definition, first coined by Markus Brunnermaier at Princeton:

Bubbles are typically associated with dramatic asset price increases followed by a collapse. Bubbles arise if the price exceeds the asset’s fundamental value. This can occur if investors hold the asset because they believe that they can sell it at a higher price to some other investor even though the asset’s price exceeds its fundamental value.

This captures all of the main elements of a bubble, as commonly understood by investors. It also enables us to develop a way of measuring the likelihood that a bubble exists in actual market data at any given point of time. The Fulcrum research paper explains the methodology in detail…

So it all comes down to the market definition of:

“fundamental value”

and that, dear reader, is where we’d love to hear your thoughts. How do you define the fundamental value of a particular patch of San Francisco real estate?

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