Chronic. When we comment on the very sharp rise in real estate prices (+ 11% over one year in the United States despite the crisis), stock prices of technology companies (up 67% in one year in the Nasdaq index, 491% for the Tesla share), the price of bitcoin (+ 710% in one year), we often speak of a “bubble”. But in reality, we need to be much more specific and distinguish what is effectively an asset price bubble from what is the effect of expansionary monetary policy, very low interest rates and excess liquidity. .
Let us first recall what a bubble is, in theory and in reality. Each asset (financial, real estate, company share) has a fundamental value, which is the discounted sum of future income (rents, dividends, etc.) obtained by holding the asset. But the equilibrium price of the asset is equal to the sum between the fundamental value of the asset and a bubble: any bubble is indeed acceptable as long as its expected value is equal to its present value increased by a percentage equal to the interest rate. The return on holding an asset is in fact equal to the interest rate: at equilibrium, all financial assets must have the same expected return, which is the interest rate on bonds.
We can then have very strange bubble profiles. If, today, the bubble is worth 100 and if the interest rate is 2% per annum, the anticipated bubble next year must be 102. But this bubble can be worth 1020 with a probability of 10%, or 0 because it burst, with a probability of 90%. As long as the bubbles do not burst, they can increase exponentially (as in the example above, we speak of a “stochastic bubble”) and the price of the asset (stock price, real estate price, value of companies …) can then deviate considerably from its fundamental value.
Portfolio rebalancing
Although we speak of a bubble to describe the sharp rise in the prices of certain assets, it is not a bubble in the sense described above. Why ? Because it is increasingly difficult to calculate the fundamental value of an asset. Expansionary monetary policies have indeed led to long-term interest rates much lower than long-term growth rates.
In the euro area, the ten-year interest rate is barely above 0, while long-term nominal growth is around 3.5%. The discounted sum of future rents or dividends therefore does not exist (it is arithmetically infinite), since rents or dividends have a growth rate greater than the discount rate.
You have 53.02% of this article to read. The rest is for subscribers only.