Navigating Bubbles

The Shoe Shiner boy who was giving stock tips to John Kennedy in 1929 remains to this day the most salient symbol of market bubbles. But should we listen to this warning sign?

The Shoe Shiner boy who was giving stock tips to John Kennedy in 1929 remains to this day the most salient symbol of market bubbles. Kennedy's logic that if the Shoe Shine boy was giving him, an experienced stock broker, tips about the market was a sign to Kennedy that the market was well and truly at the top of a peak and ready to tumble. An insight that led to the multiplication of Kennedy's wealth by 45 times within six years of the initial stock market crash of 1929.

My Shoe Shine moments

Recently I have had a number of Shoe Shine moments which, at its core is the entrance of less sophisticated or unsophisticated investors into market as they're drawn to perceived ease with which people make money. Some of these moments I'll be sharing won't all have to do with crypto, but when people jump into things they don't understand, I feel its a sign of the Shoe Shine variety. I am not saying that the bubble is about to burst but inviting you to take note of these signs in your life.

Me

I started investing in stocks in March of 2020, near the bottom of the COVID-19 market crash for Australian stocks. My rationale was simple, relative prices are at significant lows so even if I buy the wrong stock I will probably still make money with it. It was a forgiving environment to start my tangible education of an industry I wanted to earn my stripes in. But I entered without any intimate understanding of what I had invested in, but I knew all I had to do was not necessarily be good at investing but instead be better than the other people who were doing the same as me.

Now, a year later after some success and lots of learning I'm giving general information to you about a new market that nobody fully understands due to all the variables at play. I'm almost completely positive that Kennedy would treat my knowledge with the same caution as he did with the Shoe Shine boy.

Exposure to the hype

Going back to March 2020, I had a friend who had the same approach who took a more risk-averse approach. He decided to put his money into ETFs. For those who don't know, an ETF will buy and sell a weighted basket of multiple assets within a specific field of interest. So if you buy shares in a Crypto ETF for example, you will automatically have exposure to a diverse range of cryptocurrencies - 20% in Bitcoin, 15% Ethereum, 3% Cardano etc.

Back to my friend, what he essentially wanted was exposure to the price rise in the market rather than targeting the merit of specific companies, increasing the demand (and as a consequence the price) of share prices in companies he didn't know that he owned. When there is mass ignorance of investors when seeking gains without rigorous research, an asset can become overvalued.

Wallet Growth

For a tangible example with regards to crypto, there is a very convincing sign that a lot of the rise in Bitcoin's price is owed to people who are just starting in cryptocurrency.

Number of Blockchain Wallets

Price of BTC in USD

When we compare these two graphs, we can see from October 2020 that there has been a significant correlation between the number of people creating cryptocurrency wallets and the increase in Bitcoin prices. A possible conclusion to this information is that a lot of Bitcoin's demand has been driven by new investors in the crypto market. Combine this factor with the media coverage around Bitcoin and we can conclude that the hype factor combined with the lack of institutional investment, as well as no real milestones for Bitcoin being accepted by the masses, has created bubble-like price behaviour due to people seeking exposure rather than calculating true value.

Cognitive Dissonance

So far, in essence what we have looked at is when people are attracted by a general concept plus momentum driven by price. Another characteristic of bubbles is the ignoring of warning signs. During the internet boom (and eventual bust), because internet companies typically start with an absence of meaningful revenue, people started to shift their pricing justification to metrics that historically had never been used. When companies under performed, it didn't matter. When companies missed targets, it didn't matter. Because of potential.

Its a very dangerous concept which, at the turn of the century quickly spun out of control as people chose the information they wanted to use to pump up demand for the companies they had been enamored by.

To turn back to the flagship cryptocurrency of Bitcoin, there are a number of things that people have chosen to ignore. On a fundamental level, no one knows who the founder is, but we do know that he has disappeared off the face of the planet, and at any point he could sell his Bitcoins and cause a major nosedive in the price of the currency. We also wouldn't know if he has lost confidence in his own creation in this instant, or if he is cashing out. The mystery behind Bitcoin's creation should be unsettling for people, but it has been brushed aside by retail investors.

There are also unhealthy market conditions surrounding the original cryptocurrency, with the high price volatility in addition to the over-leveraged market conditions increasing the potential downside after a sizeable decrease in the price. When people are leveraged in the market, basically they have borrowed money to purchase a specific asset and opens people up to the potential of losing more money than they put in. In January, the amount of leveraged investment in the Bitcoin market was 15 times the average indicating an already overheated market. Since then, the price has increased by 66%.

Value is Valuable

While we can verifiably conclude that bubbles can wipe out significant parts of a portfolio when they burst, the rewards for predicting them are few and far between. Historically, more money has been lost waiting for a bubble to burst versus losing value in a market downturn. In 2005 Time Magazine wrote an article about the unhealthy housing bubble which would lead to economic crisis. If you were to short the stock market at that time you would have lost money even at the exact bottom of the stock market's dip. So even if we are in a bubble, and we know its going to burst, should we pay attention to them?

Peter Lynch, the former manager of the Magellan Fund within Fidelity Investments averaged a 29% return, higher than Warren Buffett and almost all other equity fund managers that he competed with. Famous for his simplistic approach he has a number of lessons on where most people go wrong. During the protracted market downturn in the 1970s, Lynch bought Tacobell stock at $7 after it had dropped from $13. It continued to decline to $1 before an eventual rise to $24 over the course of 10 years.

He extracted 3 lessons from this for us to learn from:

• Deal in facts not forecasts - There is no use trying to predict what's going to happen because no one actually knows. Deal in what the present condition is now, and if you invest in a good asset it will go up if you did your homework

• If you're going to do something in the near future, do it today - Extending on the previous point, if you think you're going sell your cryptocurrency and try to time the market, you're better off doing it today. You're either confident in your investment, or you're not.

• If you want your money back within two years, do not invest - Tacobell went on a very scary journey to the top for Lynch, but logic is always rewarded in the long-run, but not so much in the short run.

Lynch's investing philosophy was applied to stocks almost entirely, and what all stocks are is an investment in a share of a company's productivity. Cryptocurrency is different to that in a nuanced way, because there are many different currencies that have different qualities, so be careful on how you digest this next part.

Warren Buffett during his entire life in the public sphere lauded the simple methods that can yield high rewards in stocks, noting that a $10,000 investment in the S&P (American stock market) in 1945 would be worth over $51,000,000 today, during which there were half a dozen serious periods of downturn in the market. This is because the production a company provides will always be rewarded. But when you don't invest in something that doesn't produce anything, then the rewards would be much less if any. Buffett then illustrates that the same $10,000 investment at that time would only be worth $400,000 today if it were invested in gold, the classic 'store of value' asset.

Cryptocurrencies have been likened to gold in its store of value characteristic, but that can even be debated as to whether or not that is true. There are currencies that offer significant utility, and for those, I would say in the long-run, would worry me less if I felt I was caught in a bubble. It would allow me to take the Peter Lynch, Warren Buffett level of patience and courage to hold the asset during periods of significant downturn.

Going back to the internet boom, because I think it bears remarkable similarities with the rising cryptocurrency market, the reason for the steep incline in internet tech stocks is because people got carried away by how much they could achieve in the near future. Even though all of these stocks fell significantly afterwards, it didn't mean they were necessarily wrong to get excited. Some of those companies don't exist anymore, but others are the biggest in existence today.

Amazon's price during the internet boom soared to over $100 before depressing to under $20. But at the time of writing comfortably sits firm near the top of all companies at over $3100. The difficulty for us is sorting the duds from the winners while investing in a market bubble environment, but sound logic and investing in utility rather than just a story is a good place to start.

Key Takeaway

When navigating through bubbles, you will significantly limit the downside when you invest in intrinsic value. The idea of Amazon as an online bookstore was the bedrock for e-commerce, one of the biggest industries in the world today, so having an awareness of the potential for your investment to transform into something different is a key part of hedging against bubbles.

Coming Soon...

Pathways to Failure

What I like about Ethereum

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