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Hackernoon logoPlaying the Financial Bubble Game by@arnoldkling

Playing the Financial Bubble Game

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@arnoldklingArnold Kling

We are all at a wonderful ball where the champagne sparkles in every glass and soft laughter falls upon the summer air. We know, by the rules, that at some moment the Black Horseman will come shattering through the great terrace doors, wreaking vengeance and scattering the survivors. Those who leave early are saved, but the ball is so splendid no one wants to leave while there is still time, so that everyone keeps asking “What time is it? What time is it?” but none of the clocks have any hands
— George J. W. Goodman, aka ‘Adam Smith’ Supermoney (1972)

I obtained my financial independence during the Dotcom bubble of 1999. I was one of the lucky winners of that particular game. I never played in a financial bubble game before, and I never will again.

I didn’t set out to play in a financial bubble game. I started a web site for home buyers back in April of 1994. A year later, I partnered with a relocation services firm. Until 1997, we tried to earn the most profit possible. Then, we were acquired by a large media company, which told us to concentrate on something called EBITDA, which is a measure of profits that does not deduct expansion costs. That is, we were encouraged to expand, but we remained fairly conservative.

By 1999, other companies offering web-based relocation services were taking in venture capital and even going public. We saw that soon we would have to either try to go public ourselves or allow ourselves to be acquired by a company that already had issued shares on the stock market.

All of us were skeptical of the market fascination with Dotcom stocks, so we took the conservative route and were acquired. That was a good choice, because by the time we could have put ourselves in shape to try to sell shares to the public, it would have been the summer of 2000, and by then the Dotcom bubble had popped.

In fact, we were acquired by a company that I will refer to as BubbleDotCom, whose stock crashed while we were still locked out of selling it. Fortunately, our acquisition had not been paid for entirely with stock. Some of the proceeds were in the form of cash, and the cash retained its value.

In short, a bunch of investors who bought shares in BubbleDotCom provided cash to that company, which used some of that cash to buy us. The investors, except for the few that might have sold early, eventually lost what they put in. Part of their loss became the source for my financial independence. Nothing to change my lifestyle, but enough so that I don’t have to get along with anyone to earn a living.

The stock market and reality

The stock market is not always in a bubble. Shares of stock give the holder part ownership in large companies. Ownership of a real company with real profits means that you have an asset with real value. Indeed, if you could predict accurately the profits of a company, then you could precisely calculate what share in its stock are worth.

Future earnings are the reality on which stock market prices are based. But investors can disagree about where earnings are headed, so that some investors think that stocks are cheap while others think that stocks are expensive. As news plays out, some investors change their minds, and that leads to changes in share prices.

Because future earnings cannot be known with certainty, you can never be sure that a market is in a bubble until after the fact. But Nobel Laureate Vernon Smith demonstrated thirty years ago that in an experimental stock market setting, even with future earnings known so that the correct value can be calculated, bubbles frequently emerged.

Smith’s experiments showed that even when investors are aware that there is a discrepancy between stock prices and fundamental values, they continue to hold onto their shares and even buy more. I believe that what Smith found in experimental markets also can be found sometimes in the real world.

When investors are aware that stock prices are high relative to traditional indicators of value, why do they not sell? I believe that the answer lies in the epigraph with which this essay began. Bullish investors have been earning paper profits and reaping psychic rewards, and they stick around in the hopes of more. They know that what Goodman calls the Black Horseman may come at any time to ruin the fun, but they presume that they can get out while their portfolios still show a profit.

And yet it is mathematically impossible for all of the bullish investors to get out with a profit. If a stock goes from $10 a share to $100 a share and back down to $5 a share, then on average the shares bought on the way up have to be sold for less than their purchase price on the way down. If you buy into a bubble, then the chances are you will lose.

A Bubble as a Chain Letter

I believe that a bubble market acts a lot like a chain letter or pyramid scheme. A few people make a fortune in a bubble market, at the expense of a large number of people who take modest losses. The winners are those who sell close to the top, as we did with out Internet company. The losers are the many who buy on the way up and are unwilling or unable to get out before the crash takes place.

Which brings me to Bitcoin. There are many people who will tell you that they have made money by being bullish on Bitcoin. But that is delusional. In order for people to realize their Bitcoin profits, they would have to sell, and if a lot of people sold, then that would have driven the price of Bitcoin down.

Instead, it is a mathematical near-certainty that most people who believe that they have made large profits on Bitcoin are still holding most of their Bitcoin, so that their profits only exist on paper. And if Bitcoin crashes, which I expect it will, most of those people will not be willing or able to sell before their large paper profits have turned into small paper losses.

Does that mean that going short Bitcoin is a sure bet? No. There is a saying, often attributed to John Maynard Keynes, that “the market can stay irrational longer than you can stay solvent.” This makes it perilous to try to fight a mania. If you saw the movie The Big Short, or read the book, you know that if the market for mortgage securities had stayed irrational a few months longer, at least some of the bearish speculators would have been wiped out before their positions were vindicated.

But if I am correct that Bitcoin is a bubble, then somebody at some point can make a fortune by selling Bitcoin short, perhaps on the futures market that recently opened. The other big fortunes in Bitcoin will be made by the few who sell their Bitcoin while the the bulls still outnumber the bears. And once again, it is a mathematical near-certainty that most of the bulls will not get out in time.

My advice is to stay away from playing the bubble game in financial markets. Let other people buy Bitcoin. Let other people short Bitcoin. Let other people buy stock market darlings like Amazon at extraordinary multiples of their recent earnings. Instead, invest in assets where the price has a more reasonable relationship to reality.

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