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Monthly Discussion
The Bubble
Indicator
This month's
discussion topic takes up once more the bubble indicator described in An S-Shaped trail to Wall Street (pp 75-79).
The approach in
brief
Using the notion
of relative price one can objectively understand whether the market is
overvalued or undervalued and estimate how close we may be to bursting a bubble
or to bottoming out from a major dip.
The DJIA that we study and forecast in this Newsletter is calculated from
the average DOW price weighted by the share volume. This price is calculated as
the ratio of the DJIA’s dollar value over the DJIA’s share volume and is
expressed in dollars. The same ratio, but with dollar value and share volume
expressed as percentages of the NYSE totals, defines a relative price. Relative
price is nothing else but the DOW's average price divided by the NYSE's average
price.* The relative
price gives a more realistic description of how DOW moves. It may reveal, for
example, that DOW’s poor performance is not so poor after all, or that a good
performance is not that good.
It is true that DOW's performance and NYSE's performance are strongly
correlated (that's why we use the DOW as an index!) But in a particular day it
may be that the average NYSE stock gains 15%, while the average DOW stock only
3%. In this case DOW's performance must be considered rather poor. In contrast,
if some day the average NYSE stock drops by 5% while the DOW remains unchanged,
the latter's performance should be considered as rather good.
Large-capitalization stocks present
more resistance to the whims of the market (small-capitalization stocks are know
to be more "fickle"). We can therefore use the relative price as a
barometer for detecting exaggerated market moves, be it in the direction of
overstating or understating. This is a dynamic detection process, i.e., it can
only be done on the move, as things change with time. For example, if DOW's
price increases between two dates more than the DOW's relative price between
the same dates, the DOW is overstating the market and we are having a bubble
situation. If DOW's price decreases faster than its relative price, we have an
under-valued market most likely to be followed by a bull market. Large bubbles
can burst with a crash. Following a crash, the total NYSE value generally finds
itself below the real value, and a bull market is likely to follow.
During an overstated market both the NYSE and the DOW may form
bubbles, but the two bubbles do not generally grow at the same rate. The
difference between the percentage change of the DJIA average price and its
relative price is proportional to the size of the bubble. Therefore a null
difference is evidence that there is no bubble.
The bubble
indicator updated
Exhibit 3 shows that the average price and the average relative price of
the 30 industrials moved hand in hand for most of the last 32 years (most of
the points are close to the zero line). Occasionally we see important
excursions upward with price increasing faster than relative price, or downward
with relative price increasing faster. Let us look more closely at some large
excursions in each direction. From the three bubbles (in 1971, 1975 and 1987)
only the last one burst. An undervalued market preceded the first two bubbles,
which is what may have caused the formation of these bubbles in the first
place. If it is true that a bubble sometimes forms as a reaction to an
undervalued market, it may be reasonable to conclude that such a bubble is not
likely to burst via a crash but rather diffuse via a more gentle mechanism
(soft landing). After all, the amplitude of the 1975 bubble exceeded that of
1987, and yet it did not burst.
Conversely among the largest market undershoots that we see in
Exhibit 3, only the one in 1987 should be interpreted as a reaction to the
bubble that preceded it. In that light, we can say that the other four market
dips not preceded by bubbles were caused by more deeply seeded phenomena. All
the same, they were followed by bubbles, which can now be seen as reactions to
the dips.
To summarize, a bubble or a dip of the market can be viewed as action or
reaction, depending on whether it initiates a deviation from zero, or follows a
deviation from zero. The relative-price indicator obviously enhances our
ability to predict reactions more than actions.
Let me point out here that over-shoots and undershoots of the market
often coincide with bull markets and bear markets respectively. But for the
bear markets of 1977 and of spring 1997 there is neither significant overshoot
nor undershoot. We must therefore conclude that the poor performance of the
DJIA in these two cases was not a correction but was simply real.
Exhibit 3.
Based on the last 32 years (points every six months), we can say that
bubbles and dips of the market do not extend beyond 25 percentage points in the
difference between the average DJIA price and its relative price. On October
31, 2002 we are in a situation of a dip.
We also see in Exhibit 3
that in October 31, 2002, the market was on the dip side, which can be
interpreted to some extent as a reaction since some sort of overvalued market
preceded it. However, the bubble indicator was at -17% on October 31, 2002.
This value is large enough so that even if part of is due to a reactive
correction there is reason to trigger a bull market, as it happened following
the dip of October 30, 1998. Bubbles burst and dips trigger bull markets when
the amplitude of our bubble indicator approaches 20 percentage points or more.
Exhibit 4 shows a study
with variable sampling and finer time resolution. We are looking at daily data
to detect a bubble with respect to October 8, 1998. This date was chosen for
two reasons. First because it corresponds to a time period when the DJIA was
again at present levels, and second because it also was a time of an
undervalued market. We see in Exhibit 4 that the DJIA kept building a bubble until
early 2001, then went through a dip, corrected itself, and then fell again to a
negative level, thus corroborating an undervalued market at present time.
Exhibit 4 demonstrates
better than Exhibit 3 the classic by now bursting of “The bubble” because six-month
sampling is too rapid to describe a process spread over a whole year. But
whether we look at the market from one semester to the next, or with respect to
October 8, 1998, the conclusion is that the market today is undervalued.
Reaction or not, some further recovery should still take place.
Exhibit 4. Daily data indicate the existence of an
undervalued market with respect to October 8, 1998.