Many assets show signs of being immersed in bubbles right
now. The most obvious example is the cryptocurrency speculation, which
includes Bitcoin, the numerous and rapidly-multiplying Bitcoin alternatives
and, more recently, the stocks that are involved in cryptocurrency ‘mining’.
Other examples are the broad US stock market, the stocks of companies
involved in social media and/or e-commerce, the market for junk bonds, and a
group of junior mining stocks where just the hint of a possible discovery has
led to spectacular price gains and market capitalisations that bear no
resemblance to current reality.
The most enthusiastic participants in each bubble believe
that although bubbles exist elsewhere, there is a special set of
circumstances that justifies the seemingly high valuations in the asset that
they happen to like. For example, many of the cryptocurrency enthusiasts
believe that the US stock market’s valuation doesn’t make sense but that
Bitcoin’s valuation does, and many stock-market bulls believe that the
S&P500′s current level is justified whereas Bitcoin’s valuation is
ridiculous. However, the bubbles are all related in that they all stem from
the returns on conservative investments having been driven to near zero by
the actions of central banks.
Now, just because an asset is immersed in an investment
bubble doesn’t mean that it should be avoided. Buying something after it
enters bubble territory can be very profitable, because huge gains will often
occur AFTER valuation reaches a point where it no longer makes sense to a
level-headed investor. The problem is, if you ‘know’ that a particular asset
is immersed in a bubble then you will be constantly on the lookout for
evidence that the bubble has ended and that the inevitable implosion has
begun. In effect, you will constantly have one foot out the door and will be
acutely vulnerable to being shaken out of your position in response to a
normal correction.
A related problem is that once something has entered
bubble territory the normal corrections tend to be vicious. Each correction
will look like the start of the ultimate collapse, so unless you are a true
believer (someone who believes so strongly in the story that they are
oblivious to the absurdity of the valuation) you will be unable to hold
through. For example, during the first half of September the Bitcoin price
had a peak-to-trough decline of about 40%. This looked at the time as if it
could be the first leg of a total collapse, but it turned out to be just a
short-term correction. Only a true believer in the cryptocurrency story could
have held through this correction.
Eventually, of course, a vicious price decline turns out
to be the start of a bubble implosion. The true believers will naturally
hold, thinking that it’s just another bump on the road to a much higher
price. They will continue holding while all the gains made during the bubble
are given back.
An implication is that you need to be a true believer to
do phenomenally well from an investment bubble, but if you are a true
believer then you will be wiped out after the bubble collapses.
Alternatively, you may decide to participate in an
investment bubble while knowing it’s a bubble. In doing so you may be able to
generate some good profits, but in general you will be too quick to sell.
Therefore, while the bubble is in progress your profits will pale in
comparison to those achieved by the true believers, although you will stand a
better chance of retaining your profits over the long haul.
The worst-case scenario is to be a non-believer and
non-participant in a bubble, but to eventually get persuaded by the
relentless rise in price that special circumstances/fundamentals justify the
valuation and that a large commitment is warranted. That is, to become a true
believer late in the game. This worst-case scenario is what happens to most
members of the general public.
[This post is an excerpt from a recent TSI
commentary]
