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Financial Bubbles in the 21st Century


Posted: Tuesday, January 19th, 2021

Estimated Reading Time: 5 minutes

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2020 was such an extreme year for financial markets that the media often reminded investors of the historical financial bubbles and what they triggered. For example, the dramatic rise in the stock market prices during the pandemic, especially in the tech sector, immediately trigger comparisons with the 1992-2002 tech crisis.

Or, the parabolic advance of Bitcoin. Viewed by many as an alternative digital investment, it’s advance resembles the tulip mania of 1634-1639. Most recently, the Financial Conduct Authority (FCA) in the United Kingdom warned investors in crypto that they are at the risk of losing all the money poured into crypto assets.

Financial Bubbles

What makes a financial bubble, and is the stock market one? Also, can we talk about financial bubbles in the cryptocurrency market?

Traits of Financial Bubbles

Exuberant market behavior leads to financial bubbles. If you want, they represent the opposite of outright depression. When a market drops more than 20% from the top, it enters bearish territory. At least this is the dogma in technical analysis.

From a fundamental point of view, two consecutive quarters of negative Gross Domestic Product (GDP) growth signal the start of a recession. A recession starts with the GDP contracting and then the more the conditions persist, the more people will talk about a recession, and not a contraction anymore. Furthermore, the more the recession persists, the more people will talk about depression, not a recession anymore.

The same is valid with financial bubbles. The difference is that during bubbles, the market (any market) advances exuberantly without any logic whatsoever. It starts with a boom, continues with euphoria, profit-taking follows, and then panic dominates the market.

It is said that the prices in a bubble greatly exceed the intrinsic value of the assets. What is the intrinsic value of the tech sector’s companies? Or, what is Bitcoin’s intrinsic value?

Nasdaq 100 and the U.S. Tech Sector

The Nasdaq 100 is the benchmark for the U.S. tech sector. Because the U.S. stock market is the largest in the world and the U.S. tech corporations dominate, the Nasdaq 100 is viewed as the world’s benchmark in tech.

During the 2020 stock market meltdown, the Nasdaq 100 was the one stock market index that recovered the fastest. When compared to the S&P500 or the Dow Jones Industrial Average (DJIA), the move lower in the Nasdaq 100 merely looked like a regular correction.

The bounce that followed and the quick move to new all-time highs during a pandemic, took many by surprise. The thing is that most tech companies benefited from the changes the pandemic brought – remote working, rise in e-commerce, among others. Suddenly, investors were bidding for sky-high valued companies.

Financial analysis refers to interpreting a company’s financial statements and forward guidance provided by MD&A (Management Discussion and Analysis) to find out the intrinsic value. Or, the price that represents the fair value of a company.

Analysts look at income, cash flow, and balance sheet statements to assess the company’s financial position and performance at one point in time or over a certain period. Armed with that information, the process of valuing a company involves calculating all kinds of financial metrics like net income margin, return on common equity, price-earnings ratios, and so on. Finally, analysts compare the results across the sector and so they draw a conclusion if the price the company trades at is close to the intrinsic value, overvalued or oversold. This is just a simple way of explaining the process.

Remember that during financial bubbles, the boom and euphoria stages mean bidding for prices at illogical levels.

Tesla Enters the S&P500

December 2020 marked an important milestone. Tesla, the investors’ darling, entered the venerable stock market index.

It was the largest S&P500 inclusion ever. At the time of the addition, Tesla traded at 186 times (!) forward earnings and every $11.11 move in Tesla’s share price leads to a 1% move in the S&P500 index. Tesla rose almost 700% during the course of 2020 – a year marked by the COVID-19 pandemic.

Tesla Share Price

Bitcoin – One of the Biggest Financial Bubbles in History?

Bitcoin made headlines again in 2020. In December 2017 it rose close to $20,000 and subsequently collapsed to $3,000. If anything, the price action resembles what markets do when financial bubbles burst.

But somehow Bitcoin made its way back. While acting differently than an alternative investment (i.e., it dropped with the March 2020 stocks meltdown), it decoupled from any correlation in the last part of the year.

More precisely, it rose from $10,000 to $40,000 in less than three months. No other financial asset experienced such price action. Is Bitcoin a financial asset? According to some, Bitcoin’s intrinsic value is not even zero, given the environmental disaster that it leaves behind.

Bitcoin Electricity Consumption

Bitcoin mining consumes enormous amounts of electricity. It recently exceeded the annual electricity consumption of a country the size of the Netherlands or Argentina. Because the world’s electricity production mostly comes from fossil fuels, the exponential rise in Bitcoin’s electricity consumption greatly damages the environment.

 

Bitcoin Fossil Fuel

One question would be – what for? Critics of Bitcoin say that it is nothing but a complicated Excel spreadsheet. Others add that it should be taxed heavily if it has such negative effects on the environment. Finally, supporters argue that this is the only true form of decentralized money, far from the governments’ power to influence its value.

And so we have the true characteristics of a financial bubble. Did the price reach the profit-taking phase?

Financial bubbles tend to be obvious but very difficult to time. The irrational, exuberant market behavior may last longer than many investors remain solvent. For instance, the short interest in Tesla declined dramatically as shorts were obliterated by the parabolic move higher. Or, the short interest in Bitcoin – who is brave enough to sell Bitcoin when the price rose four times in less than three months? What if it does the same in the next quarter?

Financial bubbles build on the premise that investors hope they will find a buyer for the asset at higher prices. As long as this holds true, the price can only rise.

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