Bubble indicators for the stock market aren't flashing red yet

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Is this the time to run in the opposite direction from an overvalued U.S. stock market that depends on a long-in-the-tooth recovery and the dubious merits of Trumponomics to keep going even higher?

Common sense suggests the answer is yes. But research begs to differ.

Three Harvard academics – Robin Greenwood, Andrei Shleifer and Yang You – argue that a big run-up in stock prices doesn't necessarily mean investors are doomed to future disappointment.

In a paper entitled Bubbles For Fama, they look at cases in which stock prices within a sector have doubled over two years. They find – rather surprisingly – that the big gains aren't usually offset by periods of unusually low returns over the subsequent two years.

There is a catch, however. Surging prices may not mean lower returns lie immediately ahead, but they do significantly boost the odds that the stocks will crash.

If this sounds contradictory, think about the various forces that can drive markets higher. In some cases, the lift is a genuine shift in industry fundamentals.

In these situations, stock prices climb and keep on climbing. For instance, U.S. health-sector stocks more than doubled in price between April, 1976, and April, 1978.

They continued to rise by an average of more than 65 per cent a year for the next three years.

Such happy outcomes contrast with cases where inflated expectations provide the fuel for gains. The dot-com bubble of the 1990s, or the big surge in mining stocks a decade ago, rested on fundamentally flawed assumptions about the outlooks for Internet services and minerals. Both booms were eventually followed by sudden, spectacular plunges.

But both in cases where stock-price gains are based on genuine shifts in industry outlooks and in cases where they reflect nothing but giddy optimism, an investor can enjoy good returns for a long, long time.

"Bubble peaks are notoriously hard to tell and prices often keep going up, at least for a while, before they crash, leading to good net returns for an investor who stays all the way through," the Harvard trio write.

The ideal strategy, of course, would be one that would ride overvalued markets upward as they get even more overvalued, but step aside before they crash.

Unfortunately, the authors don't address the current situation in the United States, where the entire stock market has nearly tripled since its low in early 2009.

As impressive as that rise has been, it falls short of their definition of a bubble, which demands that a sector shoot up at least 100 per cent within two years.

Still, their paper provides some intriguing thoughts about how investors can spot bubbles in the making – something many authorities have argued is impossible.

For instance, Eugene Fama, a Nobel laureate and University of Chicago economist, has long maintained that the stock market is efficient in the sense that it quickly absorbs available information and incorporates it into stock prices.

An efficient market can stumble and misprice stocks if its rational assumptions turn out to be wrong.

However, those mispricings will only be evident after the fact.

A truly efficient market cannot be irrational based on evidence available at the time because, by definition, it always reflects the relevant information.

Therefore, bubbles in the normal sense are impossible, according to Prof. Fama and kindred thinkers.

"Statistically, people have not come up with ways of identifying bubbles," Prof. Fama said last year.

He pointed out that critics called the dot-com boom a bubble as early as 1996 – and the market went on to double after that, demonstrating that the bubble watchers weren't all that accurate after all.

In contrast to Prof. Fama, the Harvard researchers argue that a handful of tell-tale signs can help identify bubbles.

Among those bubble markers are high levels of volatility, lots of share issuance, stronger performance by new firms than old, and a sharp acceleration in the growth trend. All of these indicators reflect investors rushing toward "a new Eldorado," the trio argue.

So what can investors conclude regarding today's market? The Harvard researchers aren't saying, but none of their bubble indicators are flashing red, suggesting that the Trump bump for U.S. stocks may not be over yet.