Investment Bubbles - Can They Be spotted?

May 14, 2018 | Alan MacDonald


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while bubbles are self-evident in retrospect, they are very difficult to see in the moment, particularly if you accept rising prices as evidence of value. A clue in the recent case of Bitcoin would be that only 8% of Bitcoin owners said they bought

Investment bubbles – Can they be spotted?

The latest investment bubble to return to earth has been Bitcoin. In late December 2017 and early in 2018 the cryptocurrency came close to US$20,000. Today, it trades around US$5,300.

True believers in cryptocurrency will be quick to point out that cryptocurrencies are far from disappearing. They will tell you that these channels of exchange are free from the interference of corrupt governments or bad finance policy, and represent a real and hard-to-manipulate alternative to conventional currency.

The reality is that bubbles are always built on a foundation of true value. There has to be something real in order to gain the enthusiasm and interest of the investing public. At some point, however, the fair value can become wildly exceeded and it goes from being an investment to speculation to, finally, a bubble.

In the tech bubble of the late 1990s, the excess seems obvious in retrospect. One of the darlings of that time was JDS Uniphase (or JDSU, currently Viavi systems). JDSU started at $1.25 (The IPO was $12.50 – but adjusted for stock splits it would be $1.25) and hit $22.68 in 1998, $636 at its peak in 2000, and currently it trades at $9.52.

The company today – 23 years after IPO – is a good outfit, employs 3,000 people and provides needed optical solutions. If you bought it at $1.25 in 1995 and you held it to today, you’d have a reasonable investment.

But the majority of speculators would have bought the stock somewhere well north of $100 a share and likely came to regret the decision to do so.

So while bubbles are self-evident in retrospect, they are very difficult to see in the moment, particularly if you accept rising prices as evidence of value.

A clue in the recent case of Bitcoin would be that only 8% of Bitcoin owners said they bought it as a form of currency, the other 92% were buying it as an investment.

Fair value and maximum value are two radically different things. In the case of Viavi systems, you might argue that fair value is the current “free of frenzy” $9.52 – but we know that the maximum value was in fact the $636.

Barclays, in their “Equity Gilt Study 2018,” has recently tackled the thorny question of what makes a bubble. The model they use is not conventional valuation metrics because, of course, these don’t apply in cases of speculative frenzies. Investors use their imaginations and the extrapolation of past gains to justify ever increasing heights.

Instead, they suggest that bubbles are much like infectious diseases. The bubble starts with a small number of asset owners (the infected). New buyers are drawn in (catch the bug) because they witness dramatic price increases and fear they will miss out. The majority of the population is immune and will never catch the bug.

The faster the prices rise, the wilder the portion of the population that is susceptible will become. The panic-buying drives the price quickly higher. But eventually the portion of the population that can catch the bug comes to an end.

At this point the prices begin to come down, and because the bubble was driven on expectations of outsized gains, the bubble begins to deflate – sometimes slowly but often quite quickly, until it reaches a fair value driven by conventional business valuations standards.

The Barclays model seems to fit the Bitcoin and the tech wreck history pretty well. One could argue that most stocks related to cannabis could currently fit into the same mould. The challenge, of course, is that if you are in a bubble you may sell and have to live with some regret of not catching maximum value. But if you are in an investing bubble, after the dust settles, most sellers will be relieved that they got away with some, if not all the value.