How To Tell If We Are In A Stock Market Bubble

Joseph Saluzzi (jsaluzzi-at-ThemisTrading.com) and Sal L. Arnuk (sarnuk-at-ThemisTrading.com) are co-heads of the equity trading desk at Themis Trading LLC (www.themistrading.com), an independent, no conflict agency brokerage firm specializing in trading listed and OTC equities for institutions. Prior to founding Themis, Sal and Joe worked for more than 10 years at Instinet Corporation, pioneers in the field of electronic trading, and at Morgan Stanley.

~~~

Bubble.  The word keeps popping up a lot lately in the financial markets.  After the internet bubble in the late nineties and the more recent housing bubble, investors are constantly trying to identify bubbles before they happen and make sure they do not get caught up in them when they bust.  The classic 19th century book “Extraordinary Popular Delusions & the Madness of Crowds”
by Charles Mackay details the mentality of how bubbles are formed:

“We find that whole communities suddenly fix their minds upon one object, and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion, and run after it, till their attention is caught by some new folly more captivating than the first. Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”

Today, we are faced with a second wave of possible Internet bubbles.  The recent sharp rise in the IPO LinkedIn has caused some to say that we are already in another bubble.  Yesterday, we got news that Groupon has filed for an IPO even though the company has not turned a profit yet (no doubt they felt the timing was right after the success of LinkedIn). The WSJ has a headline today that reads “Groupon to Gauge Limits of IPO Mania”.  But how do we really know if this is a bubble?  Most bubbles pop and leave a tremendous amount of wreckage in their path before they are even identified.

Three academics think they have the answer to identifying bubbles. Professors Jarrow, Protter and Kchia have recently written a paper titled “Is there a bubble in LinkedIn’s stock price?” http://arxiv.org/abs/1105.5717 You may remember Professors Jarrow and Protter also from their other recently released paper “A Dysfunctional Role of High Frequency Trading in Electronic Markets” Read Paper Here where they argued “high frequency traders can create a mispricing that they unknowingly exploit to the disadvantage of ordinary investors”.  We liked that paper alot.

In their latest paper, the Professors have developed a “procedure based on a sophisticated mathematical model for detecting asset price bubbles in real time.”  They chose to test their model on LinkedIn stock and guess what, they found that LinkedIn is in a price bubble.   Their paper is very interesting but we must admit the math calculations which they use to prove their model are way above our pay grade.  We encourage any of you math wizards out there to check out the paper.

Now, let’s put that model to work on Groupon as soon as it comes public.