Plausible-Future Bubble Test
Reserve the bubble label for prices no plausible future can justify
- Difficulty
- Moderate
- Time to result
- ~days to results
- Steps
- 5
- Confidence
- 96%
The plausible-future test distinguishes an expensive asset from a true bubble. Begin with current valuation and calculate what future earnings, growth, inflation, or required returns would have to look like for an investor to earn an acceptable return. Use assumptions that are generous but not wholly ridiculous. If even those assumptions cannot approach the current price, the bubble label becomes defensible. If a credible scenario still exists—Japan-like stagnation supporting very low bond yields, for example—the asset may be historically expensive without being demonstrably irrational. This distinction matters because “bubble” implies unusual certainty, potential insanity, and often a recommendation to short. Even correctly identified bubbles can inflate for years, so the valuation diagnosis must remain separate from the timing decision.
Origin
Extracted from Masters in Business, where Cliff Asness placed his definition between Eugene Fama's skepticism of bubbles and Robert Shiller's behavioral view.
Core principles
- 01Expensive and irrational are different diagnoses
- 02A bubble requires more than historically elevated valuation
- 03Test generous assumptions before rejecting all rational explanations
- 04The existence of one plausible acceptable outcome defeats a confident bubble claim
- 05Valuation can forecast long-run returns better than short-run timing
How to run it
- 1
Measure current valuation
Estimate the return implied by the current price using appropriate earnings, yield, or cash-flow measures.
Pro tip Compare several valuation models rather than relying on one ratio.
Watch out Historical extremity alone does not establish a bubble.
- 2
Build favorable scenarios
Assume strong but defensible growth, earnings, inflation, or investor return preferences.
Pro tip Use the optimistic edge of reasonable forecasts to challenge your own bearish view.
Watch out Do not use impossible assumptions merely to rationalize the price.
- 3
Calculate attainable returns
Determine whether any plausible scenario produces a remotely acceptable long-term return from today's price.
Pro tip Evaluate real and nominal returns separately.
Watch out A low expected return is not automatically a negative expected return.
- 4
Choose the correct label
Call the asset expensive when expected returns are low but plausible justification remains; reserve bubble for cases where no plausible future works.
Pro tip Express uncertainty explicitly when scenarios are sensitive.
Watch out The bubble label can create false confidence and oversized positions.
- 5
Separate diagnosis from timing
Decide independently whether and when to reduce, hedge, or short the exposure.
Pro tip Size any contrarian trade so it can survive further price divergence.
Watch out A correct long-term valuation view can still lose money if implemented too early.
In the wild
Asness tested the technology boom with extremely favorable earnings forecasts and lower required stock returns. Even those generous assumptions could not come close to prevailing prices, supporting a bubble diagnosis before the crash.
→ The market met the framework's high threshold for a genuine bubble.
Real bond yields near zero looked exceptionally expensive, but a Japan-like scenario could still allow bonds to perform acceptably. Because that future was possible even if not the base case, Asness preferred the label expensive rather than bubble.
→ The framework produced a cautious valuation warning without claiming irrational certainty.
Common mistakes
Equating expensive with impossible
A historically high price can imply poor returns while remaining rational under a plausible economic scenario.
Using valuation as a trading clock
Long-horizon valuation measures may identify low expected returns without revealing when prices will reverse.
Ignoring survival requirements
Shorting a real bubble too early can still force an investor out before the thesis succeeds.
Is it for you?
Best for
It is best for long-term investors and analysts assessing unusually high asset prices.
Not ideal for
It is not ideal as a precise short-term market-timing signal.
From the transcript
“The definition I like a bubble is it's still subjective, but it's I can't come up with any plausible future scenario where this yields a…”
“Bubble has a level of assurance, it has a level of insanity. It is a level of you should go out and short this thing.”
“I'm screaming more expensive than history. Lower your expectations, which isn't the same as a bubble.”
From the episode
Masters in Business: AQR Scott Cliff Asness (Audio)