Jeremy Grantham on Bubbles

Bubbles are important for the country because there is nothing more dangerous and damaging to an economy than a great asset bubble that breaks. And this is something the Fed never seems to get. … We looked back as far as we could, [of the 34 bubbles we found over the years], 32 have moved all the way back down to the trend line that existed prior to the bubble forming. There were no exceptions. The two that are outstanding, the UK and Australian housing bubbles, form a unique and interesting subset caused by, I believe, floating rate mortgages. The mortgages came down so fast that they protected the bubble, and now we have to see what happens when interest rates rise. But if they do not, in both cases, go back to the old trend line multiple of family income, which is what should drive house prices, it will be the first time in history that such a bubble has not broken. This is not something that I would want to bet on if I was thinking of buying a house right now.

-Jeremy Grantham, Interview with the Financial Times, 19 Apr 2010

Grantham defines a bubble as a 40-year event. If he knows the price and volatility of an asset, he can work out what a 40-year event is.

My informal working definition for a bubble is a price rise that is at least two standard deviations above trend. My assumption is that prices never follow a random walk. Rather prices are influenced little enough by past price movements below two standard deviations that a Gaussian bell curve is a good approximation of price data.

Above two-standard deviations the psychology of prior price movements starts to dominate price activity and a bubble forms in which power law characteristics come into play. Mark Buchanan and Benoit Mandelbrot each wrote books on this phenomenon. Both are on my reading list on the site.

Buchanan’s concept of "the critical state," a point at which a system reaches a tipping point into instability, is key in understanding market dynamics and bubbles. The critical state is something I have long wanted to write about as I consider most VaR-type models for markets with two standard deviation movements to understate market risk. This is a central lesson of the housing bubble and credit crisis.

I will definitely explore this topic in depth in a later post. Some of the housing markets to think about in regards to the two-standard deviation rule include Canada and South Africa as well as the UK and Australia, which Grantham mentioned.

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About Edward Harrison

I am a banking and finance specialist at the economic consultancy Global Macro Advisors. Previously, I worked at Deutsche Bank, Bain, the Corporate Executive Board and Yahoo. I have a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University. As to ideology, I would call myself a libertarian realist - believer in the primacy of markets over a statist approach. However, I am no ideologue who believes that markets can solve all problems. Having lived in a lot of different places, I tend to take a global approach to economics and politics. I started my career as a diplomat in the foreign service and speak German, Dutch, Swedish, Spanish and French as well as English and can read a number of other European languages. I enjoy a good debate on these issues and I hope you enjoy my blogs. Please do sign up for the Email and RSS feeds on my blog pages. Cheers. Edward


  1. Hu Flung Pu

    “My informal working definition for a bubble is a price rise that is at least two standard deviations above trend.”

    If I recall correctly, this is the same definition Grantham uses for a bubble.

  2. Airelon

    Come oonnnnn

    A 40 year bubble?


    Any serious discussion of economics must take in the understanding of the CREATIVE / destructive cycle. There is real wealth creation during boon decades. It’s not fake. It’s not a bubble. The 1920’s gave us the toaster, water heaters, electric irons, which began to elevate the disposable income of lower classes.

    That’s not a bubble.

    Recent decades have spawned the internet, wireless communications, innovations in hybrid and electric vehicle technology.

    There is a difference between real wealth creation, and a bubble. A bubble is an inflation of an asset class for which there IS NO wealth creation. No contribution or demand on the labor pool.

    If people are going to talk about economics, they should have at least have an understanding of the basics; and understand what wealth creation actually IS

    1. Edward Harrison Post author

      That’s exactly the wrong view. If you look at any accounts of bubbles, they almost always start premised on fundamentally sound ideas. The bubble is not about wealth creation but value. Look at what Edward Chancellor said recently in regards to China:

      “Great investment debacles generally start out with a compelling growth story. This may be attached to some revolutionary new technology, such as railways in the nineteenth century, radio in the 1920s, or more recently the Internet. Even when the new technology is for real, prospective rates of growth may be exaggerated. Early growth spurts are commonly extrapolated into the distant future.”

      Read any account of the canals in Britain or the U.S., railroads (I have a great one – History of the Union Pacific Railroad), radio, autos, Eurotunnel, Internet, etc ,etc, etc. It’s the same every time. The compelling idea and growth story morphs into a bubble as near term growth is extrapolated far into the future.

      Your comment is characteristic of any early investor in these manias.

      1. Airelon

        You do realize who you are talking to right? Well … as from your comments, I can only assume you don’t. Especially with your “early” investor comments – it’s obvious you don’t realize who you’re talking to.

        It’s very public that I caught the housing bubble explosion, and top on the S&P almost … TO THE DAY. I didn’t miss deleveraging as so many did in September / October and caught the deleveraging explosion in the Dollar, and then began to catch the carry trade as it started out, and called an asset inflation in February with an explosion in unemployment. So I didn’t just call the economic top, but also caught three sides of the same issue.

        Your response continues to provide some humor … on several fronts. Especially when you begin with:

        “Look at what Edward Chancellor said ”

        See … there is the difference between you and I. I don’t need to quote someone as an authority. I AM an authority on the subject.

        Nowhere, in any of your ramblings, did you even define what wealth actually is. Without an understanding of what wealth is, you can’t even speak to the subject of bubbles, vs. creative / destructive cycles.

        1. Edward Harrison Post author

          If you want to make self-important statements about past predictions, fine. I could do the same. But, let’s talk about the issues at hand.

          In regards to wealth, that’s not the issue in my opinion. The issue is value based on the future stream of cash flows an asset spins off discounted to present value.

          Overvaluation and bubbles are based on unrealistic expectations about the value of those cash flows. Full stop.

          1. Airelon

            I don’t need to quote others, to prove my point. That was the point. Whereas almost EVERY SINGLE comment by you on this article begins with

            “If you note X, he said ….”

            ( important reference on that subject )

            So actual wealth creation is not your point?

            ARE YOU SERIOUS? IN A CONVERSATION ABOUT ECONOMICS? Wealth creation is not the point?

            Labor / employment? Innovation? Technology? Information dissemination paradigms? In a discussion as to cyclical patterns, your point is NOT these topics, and the lasting benefits that all of these provide to the next cycle?


  3. Steve Hammer

    we’re far better off in the long run having bubbles even after they’ve deflated. do you think we’d be better off without the internet bubble? sure some lost, more gained. at the end of the day, life, business and wealth creation goes on.

  4. Grazen

    Two standard deviations above WHICH trend line? Obviously the length of a trend is of critical importance – if the trend is a 20-day moving average then you’re basically talking about a simple Bollinger Band and there’s a lot of evidence that any number of stocks or even indexes can break that short term band in the absence of a bubble. If it’s a 40-year trend then there’s demographic and technology issues and any host of other issues that might be affecting the trends over such a long period of time and so this may not prove the existance of a “bubble” either. IMHO bubbles result from rapid expansions in the money supply and hence – since 1971 when the we dropped the Gold standard, there’s been a rapid increase in bubble creation.

    1. Edward Harrison Post author

      Bubbles are always predicated on easy money. That is a necessary pre-condition for the bubble’s formation. If you look at what Grantham says, he puts a lot of the blame on the Federal reserve.

      When Grantham speaks of a 40-year event he means an event under a Gaussian curve that could only happen once in every forty years based on price and volatility. He’s not talking about the 40-year trend of course.

      As a value investor, if you want to measure trend, you do want to measure over at least over one business cycle (so 10-year trend). That’s why people talk about Shiller P/E’s which are P/Es averaged over ten years:

      See section here:

  5. Ilya

    This 2SD concept is a purely mathematical, detached view of things. There is also supply/demand, you know. If you restrict supply whilst experiencing significant population growth, the prices will indeed end up more than 2 SD’s away from the trend without this being in any way a bubble.

    Morale: leave Australia alone, at least until you present some data on population trends and housing supply

    1. Crocodile Chuck

      Australian residential property current state: the ratio of median income to median house price in the Sydney market is 9.1:1. There is a free to air television show (‘Packed to the Rafters’) about grown children living with their parents because of housing unaffordability NB its been renewed. And in 2010, the Fairfax press is once again playing cheerleader to a further runup in housing prices. Yes, we know about record immigration volumes in 2009, limited land released for development and that this country is the most urbanised on Earth. But 9.1:1?? Here’s Steve Keen, on the road re: his (so far, losing) bet to a Macquarie Bank economist re: housing prices:

    2. Edward Harrison Post author

      Ilya, the data set that Grantham uses is pretty robust. All 2 standard deviation events revert to trend. Every time. So you can call this a “purely mathematical, detached view of things” but the fact is those supply/demand arguments were the same kinds of things you heard in the U.S. and Spain and still hear in the UK and Australia.

      It’s not like you can have a long-standing house-price inflation trend and jump above it without expecting a reversion to the mean. Prices will always revert via inflation or price declines.

  6. Edward Harrison Post author

    What shocks me based on the comments here is how after two massive bubbles in shares and housing people still hold on to beliefs about population growth in housing and technological innovations in shares in waving away well-documented data on bubbles and reversion to the mean.

    We just witnessed two speculative manias caused in large part by easy money where the same arguments were at play. Yet, some of you are making the same arguments again. Why would you invest in an asset portfolio where the price/earnings ratio is 30 times when the long-run average is 16? It makes no sense. Why would you invest in a house where price-income ratios are 6 times when they are normally 4? People can only live where they can afford to pay. Again, it’s a “this time is different” mentality.

    Weren’t there immigration waves and baby booms in the past? Weren’t there technological waves in the past? Steve Keen is entirely correct about Australia. There is a massive housing bubble there and it will end badly.

    1. Airelon

      You seem to have some sort of emotional tie to the reversion to the mean valuation. As if this is somehow undesirable, and are completely ignoring the fact that the innovation of technology from the previous cycles FORCES and begins the next CREATIVE side of the cycle, which leads to more innovation. It’s as if you can’t get your eyes that OFF of the overleverage that begins to manifest itself during actual bubble formation, to see the actual wealth creation. And the fact that the wealth creation assists in the next cycle

      Which ties to actual, continual wealth.

      Your comment is characteristic of any early new economist at the end of these manias.

      1. Skippy

        Aww go back to sticking a funnel in some poor smucks head so they can play the *get sheared game*.

        Um…worse Q for retail in 10 years, government stimulus winding down, houses that can’t sell at huge hair cuts, banks wont loan to people self employed even with 20% down (more like 30%) etc etc. Ohhh no unemployment for under 30s and unskilled people shoved into mining will help ha ha.

        Mining, wheat, goats/sheep and cattle…what happens when China takes a breath…eh…meat consumption lowers…agricultural tariffs start…eh.

        Skippy…losses what bloody losses…oh, they will come good on maturity….bawhhhhaaaa.

  7. Brad

    If you’re going to slip Mandelbrot and Buchanan into a conversation on bubbles you should do so with some attempt at clarity and accuracy. Aside from serving your very narrow need of ascribing the completely unoriginal definition of “tipping point” to a source so as to lend your vague thesis legitimacy, your reference to these two theorists serves no purpose.

  8. Richard Kline

    So Ed, the 2 standard deviation measure is a good heuristic. Once can look at many trend deflections and readily spot the troubled ones: it _is_ that simple. This is why some of us saw that tech stocks a dozen years back or housing five years back were seriously in bubble territory. And why Alan Greenspin’s comments that ‘who could tell if one was underway’ were risible at the time. Bubble’s aren’t subtle things, they are jarring divergences.

    Supply and demand does work—under 2 standard deviations. Demographic movements do have impact; under 2 standard deviations. Above that approximate divergene, what is occurring is pschologically induced price momentum, i.e. mania.

    Something to consider, though, is that there may well be no well-defined instability point above 2 standard deviation divergences, whether for such trends as a whole, or even for individual trends. No one really knows which straw will pop the bubblegum, or how many, or when. Too many variables in my view. What one can anticipate, though, is that any trend diverging beyond a 2 standard deviation level _is by definition radically unstable from that point on_, and liable to blow ‘at any time.’ Somebody making a shrewd play may still make a billion after that point, but the market involved will, with virtual certatinty, crash, losing all those in far, far more. Net losses can be assumed to vastly exceed net gains once the system has diverged to radical instability. Who ends with a loss and who a gain may still be in play, but it’s no stretch to call trends above 2SD ones in ‘Ponzi space’ because less money is going to come out than goes in from that point.

    1. Edward Harrison Post author

      Well put, Richard. The 2 Std Dev rule is a good heuristic for spotting a bubble ex ante and why I see Greenspan’s comments in the same dubious light.

      Your points about supply and demand and demographics are also spot on in that those are market drivers. But, at some point (around about 2 std. dev.), psychology takes over. It makes sense that people are attracted to an asset class that has risen so far above trend purely for momentum and speculation.

      But, that’s the point at which anything could happen. When I do a full write-up on this, I will probably concentrate most on Buchanan because he has a good analogy about “fingers of instability” in a pile of sand. What he shows is that many different systems reach a critical state in which any minor change in dynamics can have a disproportionate impact on the entire system because of the fingers of instability that have built up.

      Buchanan uses a sandpile as an example where adding one grain of sand to the pile could cause one, ten, one thousand or ten thousand grains to avalanche down the sandpile. What he demonstrates is that systems reach a critical state in which the bell curve wildly understates event probabilities. That’s what happened in Yellowstone when 1 million acres burned for example.

      I think Grantham’s overall point is that markets become very unstable as they become far advanced above the longer-term trendline. And while they always revert to mean, they do so in a violent and unpredictable way once you reach that critical state. That’s what crises are all about.

    2. Edward Harrison Post author


      One thing I forgot to add is that David Merkel is out with a good piece on the significance of debt in crises:

      The interesting bit for me was this line:

      “If you want to find a bubble, focus on the financing. The rise in asset prices is not sufficient, assets must be misfinanced for there to be a bubble.”

      This is a bit different than what I am saying or my interpretation of what Grantham was saying. David is distinguishing between manias like the Internet bubble and debt-fuelled asset bubbles like the housing bubble. While I think that distinction is real in terms of the destabilizing effect of debt on an economy during the bust, I would still argue that the 2 std. dev. rule is the important heuristic. And this is what I hear Grantham saying – something like “Once you get to a certain point – a 40 yr. event, it’s game over. You always get a crash.” The divergence from trend is so large and the dependence of past price on future price so large that there are no glide path scenarios out.

  9. buermann

    All this statistical reckoning seems fine for the data mining, but is this 2 std. dev. rule stemming from an observed property or is it the result of some model or another? Minsky’s distinction between normal and bubble growth being predicated on rising levels of speculative and ponzi finance would seem to have a lot more explanatory power in terms of guiding regulatory reform than trying to build a framework around cramping down asset growth when it rises over some standard deviation from the norm…

    1. Edward Harrison Post author

      buermann, the 2 std dev rule of thumb is based on models, yes. I think there are some studies out there that take this approach and I’ll see if i can dig one of them up.

      The first commenter noted about the 2 std dev’s: “If I recall correctly, this is the same definition Grantham uses for a bubble.” I remember this as well. So Grantham probably has an article on this somewhere based on his models.

      From an investor perspective, the 2 std dev rule of thumb might be useful in terms of deciding when to sell or looking for downside protection. But, I think you’re right about looking for “rising levels of speculative and ponzi finance” to guide a regulatory response.

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