“What’s a Bubble?” or is that even the right question?

NPR recently interviewed Eugene Fama and Robert Shiller, two of the three winners of this year's Nobel Prize in Economics.  As NPR notes, they are an odd couple to be honored together.  Shiller gained fame by identifying two recent major bubbles, the stock market in the late 90s and the housing market in the mid 2000s.  Fama is known as the father of the efficient market hypothesis, and a noted skeptic of "bubbles."The NPR interview asks the question, "what's a bubble?" and ultimately seek to answer, "can anyone reliably predict bubbles?"  However, these are the wrong questions.  As an investor, the definition of a bubble is irrelevant.  In fact, whether or not anyone can reliably predict bubbles is not even important.  Let's say the answer to the latter is yes, there are people who can consistently and reliably predict bubbles.  The real question that you should be asking yourself is "can I identify the guru who will call the next bubble?"Any attempt to answer this question should start with Robert Shiller.  After all, he is noted for calling the two recent major bubbles.  Not to mention that his name will now and forever be followed by the words, "Nobel laureate."  Don't we just wait for his next bubble call?  There's a problem with this logic.  As Fama notes in the NPR interview, "statistical reliability means more than two, really."  So, what if he predicts the next ten bubbles?  "Then I'd be convinced," says Fama.  So, there you have it.  Fama basically issues a "throwdown" to Shiller.  Predict the next ten bubbles, and you win.

Shiller's reply to Fama's throwdown is interesting: "Yeah, but I don't live that long. You know, these big bubbles are rare events that play out over years. They can go a long time."  Basically making this the least interesting throwdown since the time Bobby Flay won the Coconut Cake challenge.  In a way, he forfeited.  He said (paraphrasing), "if it was a game that could be played, I would win.  But it cannot be played, so challenge not accepted."Implicit in Shiller's comment is that we typically only experience a handful bubbles over our lifetimes.  This is an important point.  If we assume that you will experience 3-4 bubbles over your investing lifetime, we can say with confidence that how you invest leading up to and after the peak of a bubble will have a significant impact on your long term results.  Nail the top and bottom and you'll make a killing.  Miss it badly and you may suffer losses that you'll never fully recover from.  Herein lies the real problem.  You can't afford to miss it badly.

Given the infrequent nature, but potentially big impact of the occurrence of a bubble during your investment lifetime, they present a particularly difficult challenge.  If you are going to try to sidestep the crash that follows the next bubble, how do you decide which guru you are going to hitch your wagon to?

This brings us back to the real question, "can I identify the guru who will call the next bubble?"What I wonder is how you would even go about making this selection.  In my mind, you would look for two critical criteria.  First, does the guru have a system that is sound, logical and likely repeatable?  In other words, if it's skill rather than luck (which we really can't know for certain), is the skill truly above that of other players in the game?  Second, what is his track record?  How many bubbles has he correctly called and can we attribute the calls to his skillful process?

Using these two questions to evaluate Shiller, he would certainly pass muster.  He has an detailed system of valuation and a checklist of questions to determine if an asset is experiencing bubble pricing.  He is, after all, a Nobel laureate.  On the question of track record, he's batting a thousand.  Two for two.

What are we to conclude?  He has a system that sounds logical and a perfect track record, but a sample size of two.  The problem goes back to frequency of bubbles.  There simply aren't enough bubbles over the course of an analyst/guru's working lifetime to prove with statistical reliability that the process is sound, logical and repeatable.  As we saw in the saga of Bill Miller and the Legg Mason Value Trust fund, a repeated series of success does not equate to the magic formula.

The real risk you bear by allowing your portfolio to be guided by a market timer, like Shiller is that if you didn't follow his advice on the first two bubble calls, what if you hop on board for the third call only for him to be wrong this time?  He would still be two for three, and praised by the financial media (he's a regular guest on CNBC), but as an individual investor, the damage to your portfolio would be potentially unrecoverable.