Editor’s note: This article was first published in December 2017. The Berkshire Hathaway share price of almost 300,000 dollars, the view that most stock markets were overvalued and the Bitcoin prices it cites and speculates about all reflect market conditions at that date.
Sometimes the word “bubble” gets used loosely to refer to the high price of an asset, but in reality a bubble in an asset, a market or an economic cycle is not only about a high price. Even a high price is relative, and it has to be compared with value.
You could invest in a share or an asset that shoots up 1,000% in two days, and that does not mean the asset is turning into a bubble; it could still be very cheap. You would simply have to see whether its spectacular rise is justified by the fundamentals.
For example, there are shares such as Berkshire Hathaway (Warren Buffett’s company) that trade at almost 300,000 dollars each and are nowhere near the concept of a bubble. On the other hand, there are shares trading at 15 dollars that are clearly a bubble.
I’m not sure whether to call it a financial bubble, an economic bubble or a price bubble. For our purposes it makes no difference.
What should we analyse to know whether an asset is a bubble?
First of all, the idea of a bubble comes from “something formed of air or gas that tends to rise.” When we apply this to financial markets and assets, the reasoning is simple. One form of bubble is when people are selling you air and investors are buying it, pushing up the price of the asset even though its value no longer matches that high price.
Put in more technical, financial terms, a bubble is a rapid, dizzying climb in the price of an asset when that rise is not justified by the asset’s fundamentals and is created solely by exuberant market behaviour or by investors’ irrationality.
See also: The 4 phases of a bubble
When does the bubble burst?
The bubble deflates the moment there are no more investors willing to buy at such a high price, which triggers a massive wave of selling that lets the air out of it.
Sometimes prices fall and stay on the floor until the asset’s fundamentals improve and investors regain confidence in it. Or, if we are talking about a listed company, the company begins to improve its fundamentals, buying becomes attractive again to new investors and the price rises once more, but this time the rise is justified by the improvement in the fundamentals.
See also: 7 safe stocks to invest in during crises, inflation and recessions
At other times, the massive wave of selling exposes a failed business and ends up forcing the company to close, because it is not a profitable business under any circumstances, or it loses investors’ credibility for good.
It is even clearer when you invest in something that has no value at all
With shares it is quite easy not to fall into a bubble, because there is an underlying business behind the share valuation, with fundamentals that even tell us whether we are buying something cheap or expensive (the company’s P/E ratio).
The fact that we buy a share above its intrinsic value does not mean we will lose money on the investment. Quite often the opposite happens if we are in a bull cycle.
We must remember that investing has more to do with human psychology than with numbers, and that investors’ irrationality and greed keep them buying at high prices for the simple reason that they expect the price to keep rising.
You may be quite sure that an asset is a bubble, but nobody can know the exact moment that bubble will burst. Right now (13 December 2017), most stock markets are made up of shares whose prices are too high relative to the companies’ intrinsic value, but this situation has been going on for several years and prices keep rising.
Why do bubbles do so much damage to the global economy?
The first recorded speculative bubble occurred in Holland from 1634 to 1637. It was known as the tulip bubble, or tulip mania.
To any sensible mind, saying that a flower could bring down the entire Dutch economy may sound crazy, but that is exactly what happened, just as the housing bubble of 2007-2008 caused unemployment and social damage similar to the crash of 1929.
When a large bubble forms, not only do many people invest their money in it, but parallel businesses also spring up around it. In the case of the housing bubble, we could say that practically the whole economy revolved around construction, and many people even left their jobs to become part of something connected with the sector.
See also: The fastest way to lose 6 million euros you have just won
So when the “mother sector” bursts, everything that was created around it comes down too.
How can you make money from a bubble?
This is probably the part that interests us most. There are two ways to make money from a bubble, especially if we are clear that there is one.
First, there is nothing wrong with taking part in a bubble, as long as we are clear that we will benefit only temporarily, and that we will take profits and set money aside cycle by cycle so that we don’t put all our capital at risk.
For example, during the property bubble I knew two brothers who were builders. Both started building on a grand scale: 24 terraced houses here, an entire housing estate there, two blocks of flats, and so on.
One of them, once he had made a good fortune, took all his profits and left the sector. The other brother was caught by the bursting of the bubble when he was most exposed. It was precisely his biggest project: 540 homes, to be exact, plus another 600 he had under way.
Both profited from the bubble, but only one of them got to enjoy the gains
So when we see an asset or a situation that is a bubble, the first way to make money is to climb aboard and take advantage of the irrationality and madness of people who will be willing to pay outrageous prices far above the real value. But we must never forget that we are speculating and that the bubble will come to an end sooner or later.
The other way to make money from a bubble is to wait for the right moment to “bet” against it (investing for a fall, short selling, going short in that market or asset), which is easy to do today thanks to the number of products available for investing against the market.
The risk here is that you may be sure something is going to collapse, but you don’t know when it will happen. As an old investor’s saying goes: “The market can stay irrational longer than you can stay solvent.”
Even so, if we get in when the market starts moving down, once we are sure the bearish party has begun, choosing the right bearish product and using leverage, the short position can be as profitable in a few months as riding the bubble could have been for years.
See also: What the OTC (Pink) market is: as profitable as it is risky
The third formula is even better: ride the bubble, take profits and use them to bet on a fall when the bubble bursts. But I insist, knowing the exact moment a bubble will burst is a real odyssey, because the start of the fall is often mistaken for a mere correction, which leads to the bear trap.
Bubbles and Bitcoin
Today the clearest example is cryptocurrencies, above all Bitcoin. In my personal opinion, as most of you already know, I consider it a new bubble, but many people are making money from its rising price. Even though I could be 80% sure that we are facing a bubble, I don’t know when it might burst.
It could reach 20,000 dollars next month, it could reach 100,000 dollars next year, it could even reach 1 million dollars. It could also fall to 100 dollars next week. As long as there are buyers willing to pay a higher price than the last one, the upward run will continue and so will the bubble.
Many people believe that if you say something is a bubble at 1,000 dollars and it ends up reaching 15,000 dollars, you got the diagnosis wrong. Nothing could be further from the truth, because a bubble that keeps inflating does not invalidate the argument that it is a bubble.
In this case we are not talking about an asset that can be analysed, because it has no intrinsic value, and its price is based on supply and demand for something that, for now, is nothing more than faith and hope that tomorrow there will be investors willing to buy it at higher prices. And that, at the risk of being wrong, is for now pure air to me, and the price it has been given is irrational. The higher it goes, the more irrational it is.
From any financial point of view, the arguments for investing in Bitcoin are not solid.
See also: The best-kept secrets of investing
Featured image: Larry-pilot, CC BY 4.0, via Wikimedia Commons.
