Beware of Bubbles

What is a bubble?

In the context of capital markets, a “bubble” is a phenomenon in which the prices of an asset or asset class are bid up to levels far beyond their historical baseline, and far beyond what any rational valuation of future prospects would warrant.

Put simply, bubbles typically arise when some legit factor causes there to be excess demand for an asset, thus forcing the price of the asset to rise. This rise in price attracts speculators looking to turn a quick profit, which in turn drives the price up further. If speculators drive its price up enough, it gets the attention of the large financial institutions. Those who are bullish on the asset or are confident that they can make a quick buck out of it begin to drive its price up at an exponential rate. A fear of missing out kicks in and fund managers buy-in simply because they see other managers doing the same.  At this point, fortunes have already been made by those who bought in at the beginning. Stories of these overnight millionaires flood the news, suddenly everyone with a few bucks to scrape together is considering joining the fold.

This is where the calls of a market bubble start to appear. Sophisticated investors familiar with past market bubbles start to cry out that there is no away these price increases can continue. However, prices keep going up. There are still enough unsophisticated investors drawn in by the tales of the overnight millionaires, hoping it is not too late. Typically there are even large price corrections, but the asset quickly returns to reaching new highs. Eventually, the voices warning against a market bubble begin to get drowned out by the crowd.

Buyers begin to think that there is no limit to how high the price can go. To quote Alan Greenspan (though he was not the first person to use the expression), “Irrational Exuberance” begins to set in. Unfortunately, it is at this point, when the least sophisticated investors have just managed to scrape some money together to get in on the action, that there is no one left who is looking to buy-in. At this point, supply starts to outpace demand, and prices begin to fall.

As soon as the this happens, all the speculators begin to panic and sell out immediately, since their decision to buy had no relation to the underlying fundamentals of the asset. No one is left waiting on the outside to buy-in on the next price correction, so prices continue to decline.  This leads to an incredible reduction in prices, leaving the common investors, those last to enter the fray and last to find out that the party is over, with empty retirement accounts and a wealth of newfound knowledge.

Past Bubbles

Perhaps the most notorious bubble occurred for tulips in 17th-century Holland, and has since been coined “tulip mania”. Tulips were brought from Turkey into Holland in the late 16th century, and the novelty of this new flower made it very sought after, driving up the price. This attracted more buyers, raising the price again and again until inevitably the priced collapsed. The price fell from around $60 to ten cents, and overnight the savings of thousands of people were completely wiped out.

While the idea that tulips could be purchased for investment purposes at any price is particularly absurd, in truth, no asset is a good investment at any price. The most recent bubbles have occurred in industries which truly had a phenomenal potential for growth, yet even so, this potential for growth was still only finite. The valuations placed on the companies in these industries were priced as if they were guaranteed to grow hundreds of times over in the immediate future.  Inevitably reality would sink in, and even if a given company was still poised to increase its earnings 10x over the next few years, it would see its stock price crumble.

The best example of this is the dot-com bubble, where the Nasdaq declined by 75% from 2000-2002. Speculation that the internet would fundamentally change the way the world operated caused buyers to believe that no price was too high to pay for internet stocks. Companies who added “tech” or “internet” to their name saw their share price increase astronomically within a matter of days. IPO’s for new tech companies were a near-daily occurrence, and investors would throw their money at these companies with little to no due diligence. While investors were right about the fact that the internet would change the world and dominate the lives of millions of people, many of these companies didn’t last more than a handful of years, and it took 20 years for the Nasdaq stock index to surpass its 2000 peak.

This is where the true danger lies, not in industries that have little prospect for legitimate growth, but in industries with awesome potential.

Today’s Bubbles

Cryptocurrencies

Cryptocurrencies have the potential to completely revolutionize the global financial system. They have the potential to circumvent central banks, allow for the expedient transfer of money across borders, and potentially lower fees, among a barrage of other potential uses. The blockchain technology that enables them to function has revolutionary potential in its own right. While some may doubt the validity of cryptocurrencies, there are very few in the know who scoff at the potential of blockchain technology.

All of this potential for growth has caused the price of the most predominate cryptocurrency, Bitcoin, to increase fifteen-fold over the course of 2017. Other cryptocurrencies have experienced a similar rise. Reminiscent of the tech bubble in the early 2000’s, companies have seen their share prices increase several times over simply because they added some variant of blockchain or cryptocurrency to their name. New coins are being launched, known as an initial coin offering (ICO), and the prices of such coins often skyrocket upon their launch due to massive amounts of promotion only to crash back down shortly thereafter.

One problem with cryptocurrencies is that there is no standard method for valuing them. They produce no earings and they give holders claim to no assets. Any intrinsic value for cryptocurrencies stems from the natural demand for them in order to complete transactions.

Alas, the increase in price over 2017 has not come as a result of an increased likelihood that Bitcoin will be used for transactions across the world, i.e due to a growing acceptance as a store of value and medium of exchange. Instead, it is the of a result of a speculative bubble. As with previous market bubbles, this situation is unlikely to end well, and it will be those who can afford to lose the least who will suffer the most.

Marijuana?

The underground market for marijuana in North America is likely in the billions. With Canada expected to legalize the substance sometime in July 2018, and many States having already gone ahead with legalization, cannabis stocks have risen through the roof. Companies with negative earnings are being given billion dollar plus valuations based primarily on speculation.

While some companies are sure to dominate this industry and warrant their sky-high valuations, just as a few select internet stocks did in the past, the vast majority of them will likely fall short. Even those which are ultimately successful will take a long time to realize the level of earnings which justifies their current valuation and may well become more affordable before that time arrives.

Unlike cryptocurrencies such as Bitcoin, there is less reason to believe that marijuana stocks are in bubble territory. In fact, whether they will ever get to that level is also uncertain, but it is a fair statement to say that the majority of these companies should be classified as highly speculative given their current valuations.

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