What’s Widely Considered As Safe Is Often Risky

Has it ever occurred to you that bubbles always happen in a new asset class that people don’t yet understand and have no idea how to value? Cryptocurrencies, Internet Stocks in the late 90s, Japanese debt, real estate and stocks in the 80s, gold in the late 1970s, Dutch tulips, etc.

Bubbles (trends) can last a lot longer than most can possibly imagine. They can be both wealth creators and wealth destroyers.

Recognising something is a potential bubble is not hard. Convincing yourself to participate in it is a lot more difficult.

Every bubble goes through three stages: first, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident by most people. Fear of missing out kicks in in stage three.

Every bubble needs sceptics and naysayers. Otherwise, there won’t be anyone left to buy. By the time most people feel it is safe to enter a trend, that trend is usually close to an end.

Here’s George Soros, explaining bubbles in a way more sophisticated manner:

First, financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times, it is quite pronounced. When there is a significant divergence between market prices and the underlying reality, there is a lack of equilibrium conditions.

I have developed a rudimentary theory of bubbles along these lines. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognise that a misconception is involved. A twilight period ensues during which doubts grow and more and more people lose faith, but the prevailing trend is sustained by inertia. As Chuck Prince, former head of Citigroup, said, ‘As long as the music is playing, you’ve got to get up and dance. We are still dancing.’ Eventually, a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.

Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions.