What is an asset bubble and how to spot a bubble?
The general definition of an asset bubble is the fast inflated price without any fundamental justification. And this is true in theory but in praxis, it is not that easy to classify every asset with quick rising price as a bubble. Because every bubble has a story – also a fundamental potential to justify the high price.
An example is Amazon:
Before dot-com crash, Amazon was a darling of wall street because the company had a great story and the stock rose very fast.
As you can see on the chart above, after tech-bubble, Amazon’s price crashed too and the company was considered as a bubble. After the crash, it was easy to debunk the Amazon’s story or fundamental business potential because, in retrospect, the events appear more predictable. But later, Amazon showed that the company can realize its story – being an online commerce giant.
One can say if there is a self-feeding price increase, people buy just because of the rising price, then there is a bubble. But every asset with improving fundamentals and thereof increasing price has this bandwagon effect. The majority of investors and of course traders are imitators whether they are professional or not. These people can cause a rapid price increase which can awake the suspicion of a bubble but later, the high price can appear to be justified if the company’s business goes as expected.
And there is a term “a rational bubble” which is nonsense because a bubble is overvaluation of the underlying asset and therefore, it cannot be rational. But there can be a rational speculation in a bubble.
After a crash, everybody can say that there was a bubble but it would be too late. Before the crash, nobody can be 100% sure about a bubble because usually, the bubbles have a story or a fundamental potential. Maybe, we can say there is a Bubble with a high probability but in general, not with certainty. Because valuing an asset is not a science, it is an art.
If an asset’s price severely crashes people easily come to the judgment that it was a bubble without any further thinking. A crash is recognized as proof of a bubble.
Of course, this can be wrong like the above example of Amazon. But a price crash is the main concern of the investors whether there will be a recovery or not.
Thereof two questions can emerge:
Is there any mechanism, market intern or extern, to prevent a price crash?
Can a price crash/bubble be a self-fulfilling prophecy?
Those questions cannot be answered in general but only in a relation to a certain asset. Therefore, we can choose tree assets as an example:
NVIDIA $210 PEttm: 60
Nobody can objectively justify the market prices showed above with fundamental analysis. For example, Why EURUSD is 1.19 and not 0.7? It is just given by the market’s dynamic.
Suppose the parity of EURUSD suddenly declines to 0.7 without any changing fundamentals but only by market intern dynamics – out of randomness. In this case, the EURUSD would be influenced by market extern effects, for example, by governments, central banks, export-import companies etc. and EURUSD can recover and stabilize again between 1.19 – 0.7; for example, you are an American company which has a debt to a European supplier in Euro. You will buy euro if the parity declines because you will secure your obligation and benefit from the sharp decline.
The same applies to NVIDIA, only the agents would be different: investors, competitors and the company itself to buy the undervalued stock.
In case of Bitcoin, the only support is the speculators and investors who would think a sharp price decline is an opportunity and have enough funds to reverse the price drop by buying Bitcoin. If Bitcoin would have the adaptation in the real economy as a direct payment medium the cryptocurrency could have the stabilizing support from the economy.
Without any support explained above, any sharp price decline can cause a panic sell of Bitcoin and prevent or, at least, delay the adaptation in the real economy. Bitcoin can recover from a crash like dot.com but after the crash, it can be replaced by another crypto. We cannot predict how many years would the recovery of the cryptocurrencies take and also, the outcome of the recovery: maybe Bitcoin would be replaced by Ethereum and get forgotten.
In case of Bitcoin, a bubble can be a self-fulfilling prophecy because it’s adaptation heavily depends on the rising price of the Bitcoin. The same doesn’t apply to the Nvidia because the fundamentals of the company or it’s earning power are independent of the stock price.
to be continued…
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