Double Bubble, Toil and Trouble

The NY Times today posed the question "Fed Missed This Bubble. Will It See a New One?" Both Fed chairmen Alan Greenspan and Ben Bernanke famously missed the development of the dot-com and the Great Recession bubbles (even conservative News.max accepts this analysis). So, how hard is it really to identify bubbles?

In an earlier post I showed how feather forecasting from a state-space model estimated up to 1990, showed that the market was over-priced during both the dot-com and the subprime mortgage bubbles. Implicitly, the feather forecast points to a sustainable level for the market but doesn't really display the level explicitly. To do that we need to remove the cyclical components and the month-to-month shocks from the model and run a counterfactual simulation for the stock market. The simulation is displayed above. Rather than reaching almost 1600 in the peak of the dot-com bubble, the simulation suggests that the market should have been at about 600. And, 1000 would have been a better level when subprime mortgage crisis broke.

Why is it so difficult for the US Federal Reserve to identify bubbles? Part of the problem is that one of the major cyclical state variable is the US economy is driven by Fed policy. Another cyclical state variable involves more fundamental economic factors such as housing, corporate profits, oil prices and unemployment. Whether the Fed is counter-cyclical or pro-cyclical will have to be a topic for another posting but clearly the Fed is in the middle of market cycles and has trouble looking outside the box.

And, compared to my pessimistic forecast for the S&P 500, the forecast eliminating the cyclical state variables for the US economy is optimistic. In the figure above, the S&P 500 is back to pre-crisis levels by 2015. The usual disclaimers apply even more strongly to this counterfactual forecast.

At best, financial reform might reduce but not totally eliminate bubbles in the US economy. Since late 20th Century bubbles seem to last about a half decade, the pattern suggests a bubble investing strategy that would differ from the standard diversified portfolio approach--a topic for a future posting.