Let’s suppose that every once and a while an asset comes along that is extremely difficult to value. It might have an extraordinarily high value, or much more likely it will soon be worthless. One example might be a dotcom company (or mobile apps, if that’s the 21at century equivalent.) Another example might be Bitcoin.
How should Bitcoin be priced? If there is a 95% chance that it will soon be worthless and a 5% chance that it will soon hit $1000, then $30 seems like a relatively fair price. That allows for a substantial expected gain ($50 minus interest costs would be the risk-neutral price.) But Bitcoin is very risky, so investors need to be compensated with an above average expected rate of return.
Now consider a point in time where the asset is selling at $30, and investors have not yet discovered whether it will eventually reach $1000. Should you predict that the price is a bubble? Yes and no. It is likely to eventually look like it was a bubble at $30. Indeed 95% of such assets will eventually see their price collapse. That’s “statistically significant.” It’s also significant in a sociological sense. Those that call “bubble” when the price is at $30 will be right 95% of the time, and hence will be seen as having the “correct model” of bubbles by the vast majority of people. Those who denied bubble will be wrong 95% of the time, and will be seen as being hopelessly naive by the average person. And this is despite the fact that in all these cases there is no bubble, as by construction I assumed the EMH was exactly true.
This post is motivated by earlier predictions that suggested Bitcoins were a bubble at $30, and hinted it might be a bubble at $2. I predict that eventually the price of Bitcoins will fall sharply (from some level of which I am not able to predict) and people will vaguely recall:
“Wasn’t Scott Sumner the guy who denied Bitcoins was a bubble? What an idiot.”
Defending the EMH is a lonely crusade that can only end in tears and ridicule, unless you are Eugene Fama, in which case it ends in a Nobel Prize and ridicule. And I’m not Fama.
And yet the EMH is true . . . er, truish in the Richard Rorty sense.
PS. The hidden agenda of this post is that spectacular price increases after incorrect bubble calls should count heavily against the bubble model, indeed roughly 20 times as heavily as a correct call in the case above. Don’t look for reputations to be adjusted according to this metric. Markets may be rational, but the assignment of scientific prestige in bubble theory is highly irrational.
PPS. Of course many bubble proponents like Cowen and Krugman and Shiller deserve their high academic reputation, but for reasons unrelated to bubble analysis.
PPPS. Bitcoin hit $1000 today.