Extrapolation: The Root Cause behind the Bubbles

They say that there is no smoke without fire. This is true of many things and one of them is asset bubbles. It is true that all asset bubbles begin their initial upward movement based on some genuinely good positive news. However, somewhere along the way, the amount of smoke far exceeds the underlying fire i.e. to say the bubble takes on a life of its own and grows far more than what would be plausible in the light of the underlying news.

There have been multiple analyses that have been conducted to find out what really causes asset bubbles. It is truly astonishing that investors who otherwise make extremely intelligent decisions tend to make utterly foolish decisions during the course of these bubbles.

One plausible explanation is provided by the concept of extrapolation. In this article, we will study how the concept of extrapolation induces investors to make unwise decisions that have a detrimental effect on their net worth.

Concept of Extrapolation

In simple words, extrapolation means assuming that the future will be exactly like the past. In case of financial markets, extrapolation means assuming that the assets will keep on providing the same rates of return that they have done in the past. The underlying good news might have been the cause of a temporary price rise. After the news is absorbed into the price, the prices should ideally stabilize.

However, in case of financial markets, a recursive cycle begins. Higher prices in the past become the basis for expecting even higher prices in the future. This extrapolation causes otherwise intelligent investors to forget the fundamental value of the underlying asset. Valuations are made by projecting past growth rates into the future.

Why Extrapolation is Absurd ?

It is strange that economic theory shows any interest towards extrapolation. Any student of finance and economics knows the concept of business cycles. This means that recession is followed by a boom and vice versa. Hence, there is a change in both the magnitude as well as the direction of the rate of return on the investment.

This is in complete contrast with the concept of extrapolation. Extrapolation assumes perpetual growth at the same rate as in the past. Therefore, it is completely opposed to the concept of business cycles. Anyone who believes in extrapolated asset value is implicitly ignoring business cycles.

Extrapolation becomes more absurd when we wonder what would happen if the trend did indeed continue for a long period of time, let’s say a century. Prices would go through the roof! Even if we assume a modest growth rate of 7%, prices would be close to 100 times of the original value.

Value Based Investing Vs Price Based Investing

To understand why extrapolation is so powerful, we must depart from the traditionally agreed upon model of stock pricing and check out new models. It has been believed that investors consider the cash flows that can be derived as a result of the ownership of securities at a later date. They then discount these cash flows at a rate that reflects the risk. The present value derived as a result of this calculation is the fair value of the stock. Ideally people should buy the stock when the market price falls below this fair value! We call this value based investing.

However, in reality, there exist a group of investors who can be called speculators or extrapolators. These investors do not pay any heed to the intrinsic value of the security. They do not intend to hold it long enough to receive any cash flow. Their idea is to simply flip the stock as soon as possible. They buy today and sell a week later. Hence, the relevant metric for them is the recent behavior in price. If the price has gone up in the recent past, they extrapolate the trend and hope that it will continue in the future! This type of investing is called price based investing.

Fundamentals vs. Extrapolators

Fundamental changes are not completely absent in an economic bubble. Every bubble initially starts as a price rise because of positive changes in the fundamentals. As a result, investors witness a rise in price. This rise in price creates an expectation of a further rise in price. This creates a self reinforcing loop. The functioning of this loop is what continues to drive the price upwards. Therefore, the initial rise is price was justified based on the change in fundamental. It is when this loop started functioning that calculated transactions changed into irrational exuberance! The types of investors that invest at each stage are also different. In the beginning fundamental investors buy the stocks, but as irrationality starts to kick in they usually move out of the market. At the last stages of a bubble it is always the speculators that are trading in the markets.

Downward Bubbles

Extrapolation can take the price of a stock down as easily as it took it up. The same events repeat themselves, however, this time in the opposite direction. Initially a fundamentally bad news surfaces in the market. A correction takes place. However, this correction creates fear in the market and a self reinforcing downward loop is set into motion. Prices fall because people are selling and people sell because prices are falling! Downward bubbles can threaten the existence of financial systems. A case in point would be the 2008 crash.