With the stock market soaring, Bitcoin and other cryptocurrencies rising, and home prices moving up at a swift pace, an examination of what is a Bubble in prices is worth a look. Financial innovation has been one of the basic tenets that have been prevalent in many market bubbles. An early example of this was the advent of closed-end funds that came to be in the 1920s. These are investment portfolios that trade on an exchange. In this situation, these closed-end funds were new investment vehicles. The price of the traded fund got way ahead of the underlying value of its individual holdings. Things did not end well. The market crashed hard in 1929.
More recently we have seen the dot.com mania of the late 1990s and the financial crisis of 2008. In 2008, mortgages were bundled up into complex investments known as collateralized debt obligations and we also saw credit default swaps, insurance deals on risky mortgages. These new and complex investments, along with increased borrowing for real estate, led to a financial crisis of huge magnitudes. The dot-com boom was largely fueled by internet start-up companies with no earnings and no track record. These were both new innovations and perhaps, more importantly, investors were borrowing heavily to finance these investments.
Bitcoin and other cryptocurrencies are also a relatively new financial innovation. An investor in cryptocurrencies needs to view them in different lights. Are cryptos a replacement for the Dollar or other currencies, an alternative currency such as Gold, or something entirely different? Or perhaps a combination of many uses. When viewed as a dollar replacement, Bitcoin could be seen as being in a bubble. However, when being open to the other uses of Bitcoin and Cryptocurrencies, the run-up in prices may seem more justified.
Innovation and technology are always happening, and alone certainly does not constitute a bubble. When new technology becomes devices for speculation and excess is when bubbles seem to form. This is usually fueled by excessive borrowing. Currently, Covid is the Wild-Card that we have not really experienced. We are experiencing rising government debt, however debt in the financial sector is well below the 2008 peak and household debt has been rising, but rising more slowly than in the 2000’s.
Nobel winning economist, Robert Shiller defined a bubble as “ a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a larger and larger class of investors.”
As far as the stock market goes, prices are indeed high and a pullback in prices is due. Tech stocks and small-cap stocks have already pulled back recently. However, there does not seem to be a mania for U.S. stocks in any industry group. As far as Bitcoin and other cryptocurrencies, there is not a concrete method to value these currencies other than comparing prices to sales volume. The recent pullback in crypto currencies has been dramatic. This is a very volatile asset. When one man’s (Elon Musk) comments can seemingly move the price so very dramatically as occurred early this month, one better have some strong nerves to weather the ride in cryptocurrencies.
