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What are the features of an asset or the themes supporting it that increase the risk of a bubble?

1) True and simple stories: Although the underlying narrative supporting a bubble does not have to be true (sometimes they can be nonsense) the most dangerous are those which are supported by a valid and simple story. This allows investors in the bubble to answer easy questions such as (in the case of the Dot-Com bubble): Will the internet change our lives? Rather than more difficult ones such as: Which companies will benefit and what is already reflected in valuation? There is far more money to be lost when a story used to justify an investment bubble is true.

2) Transformative stories: For bubbles to successfully emerge it needs to be easy for investors to disregard traditional approaches to fundamental investment valuation. It pays therefore for the narrative underpinning the bubble to be about a seismic change, which makes it easy to ignore the warnings of naysayers as their anachronistic methods simply do not incorporate the revolution that is taking place.

3) Everyday impact: The most powerful bubbles draw in incredibly wide participation, even from individuals who would not normally make active investment decisions. The more that the story supporting a bubble in an asset relates to how we experience everyday life, the more people that are likely to become involved. If we can see and experience the story unfolding then we are more likely to buy into it.

4) Unquantifiable scale: Big bubbles need a big story. If there are obvious limits to growth then it puts a lid on speculation. A genuine bubble needs an asset where the transformation taking place means that it is difficult to limit the upside potential (in theory).

5) Difficult to value: Although most bubbles involve a yawning disconnect between the price of an asset and any prudent approach to valuation, the most significant bubbles can occur in assets that are either difficult or impossible to value. While equity market bubbles can be extreme at some point there will be a gravitational pull from fundamental realities of the asset class, but assets which are impossible to value because they have no cash flows – such as gold and cryptocurrencies – are perfect. If you cannot value an asset, who is to say what the upside could be?

This distinction leaves us with two types of assets: fundamental assets and belief assets. Fundamental assets have cash flows which means that (in theory at least) we can value it in some sensible fashion. By contrast, belief assets have no practical means of valuation, so they are priced based on what others are willing to pay. The easiest way to judge where an asset sits based on this delineation is to ask yourself – if an asset’s price was up 100% or down 50% tomorrow (other things equal) would that change my view? For fundamental assets this should dramatically alter its attractiveness, but for belief assets large price moves don’t really change anything apart from sentiment. This feature gives them a huge potential range of outcomes (from staggeringly good to disastrous) – ideal for bubble formation.

The more that an asset possesses these five features, the greater the propensity is for bubbles to develop. It is not simply about the asset, however. As Shiller’s quote highlighted, speculative bubbles are formed by people and their behaviour. The makeup of market participants matters, in the simplest of terms we can think of three groups involved in a bubble: Believers, Chasers and Luddites:

Believers: This group have fully adopted the story underpinning the bubble and approach it with almost religious fervour. Rather than being an investment view it often becomes part of their identity. They will never sell, never criticise and are able to justify any valuation. Their ardent belief either comes from developing a genuine confidence or faith in the asset and its supporting narrative, or because their financial incentives have become inextricably entwined with the continuation of the bubble.

Chasers: This group are agnostic on the story and its validity – they just care about the price movements. They buy into a bubble because performance is strong. Like believers they have little regard for valuation, but are not wedded to the asset – they will own it while it is going up because it is in their financial interest to do so. A classic member of this group are asset managers launching products based around an emerging bubble asset, they don’t believe in it – they want to make money from it. Being a Chaser can be an explicit strategy but often it is simply the strength of performance from the bubble asset that draws them in for fear of missing out or maybe losing their job. Although this is the largest group, few will admit to being a member of it – momentum investing has a bad reputation, unless you are a quant.

Luddites: This group may believe in the story supporting the asset and almost certainly consider it to be grossly overvalued. They will inevitably endure poor performance as the bubble develops and be regarded as stubborn and out of touch. Professional investors in this group will risk dwindling assets and eventually their careers.

Both the relative size and movement of these groups will be crucial to bubble formation. While Believers are important in spreading the supporting stories they will be in the minority (although their flock will increase the more extreme the performance). The size of the Luddite group will shrink as the bubble grows as some capitulate to become Chasers and others give up.

It is the Chasers, however, that are most important. This will be the largest group and dictate both the size and persistence of the bubble. Their eventual exit from the asset will also precipitate its end. 

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Although difficult to validate, my base case would be that the potential for bubbles or prolonged periods of very extreme asset class performance is greater than ever before. Increasing connectedness through the rise of social media makes for easier amplification and transmission of stories, while I would also argue that investor time horizons are contracting – making us more prone to chase the performance of whatever is working.

However we approach speculative investment bubbles – whether we choose to embrace them, chase them or ignore them – their emergence presents profound risks both in terms of the asset in question and our behavioural response to it. As a bubble inflates and the story becomes evermore persuasive, the increasing cost of missing out is likely to overwhelm the increasing risk of disastrous losses.

MSTR and BTC: Bubble?

Full: https://davidgerard.co.uk/blockchain/2024/11/22/i-hear-bitcoin-is-supposed-to-be-good-now-is-it-a-new-bubble-yet/

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Full: https://nypost.com/2024/11/23/business/janet-yellen-exiting-office-leaving-mess-behind-for-trump-team/

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Meanwhile:

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Full: https://www.vox.com/policy/387382/musk-trump-balance-budget-doge

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jog on

duc