All Financial Wisdom

Technology People Should Start to Understand What a Financial Bubble Really Is

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Bitcoin is on everyone’s lips, not just the tech media. But many technological people see this revolution as something special, unstoppable and with a completely justified price escalation.

However there is a current of opinion (many times from the world of economics) that thinks that what we are seeing with Bitcoin is nothing more than a financial bubble.

The truth is that financial bubbles are difficult to see when you are in them and very easy when they have passed. Nor are there clear theories of why they occur. Well, what is a financial bubble?

Value and price

A financial bubble is formed when an asset rises in price disproportionately, moving the price away from the intrinsic value of the asset. That is, human beings have a way of fixing prices determined by supply and demand, which can cause prices to be above or below their real value.

Although classic economic theory says that markets are efficient, the truth is that in any market, there is a lot of volatility (rapid price changes)when the value of an asset has yet to be fully determined by the market. Therefore, markets can be efficient in the long term, but at certain times the price setting is not perfect.

How to determine the intrinsic value of an asset is not easy, bubbles are difficult to detect. Someone could indicate that the best mechanism we have to determine the value is precisely the price, supply and demand. But if in the long term, the price of an asset collapses, it can be countered that we were facing a bubble, a disproportionate fixation of prices.

Past and present bubbles

The best way to visualize what a bubble is is through examples. In history. there have been many bubbles. One of the most famous ones was the tulip bubble in the Netherlands back in the eighteenth century.

If we go back to closer examples we have the dot com bubble of the late twentieth century and early twenty-first. Internet was a revolution that was going to change everything and any company that had a relationship with this “new economy” was wanted by investors, regardless of whether they were money losing machines.

At the peak of the bubble, the Nasdaq traded at 5,000 points, and by the end of 2002, it was close to 1000 points (that is, an investor who had bought a selection of shares listed on the Nasdaq would have lost 80% of his/her portfolio.

Another recent bubble was the real estate one. The peak of housing valuations was in 2007-2008, with a fall in prices from then until 2013-2015 of almost 40% (in some areas more, in others less).

This was yet another irrational bubble where people borrowed far beyond their means, and almost dragged the country to economic abyss.

As a last example we could look at the valuations of many companies at the moment. Historically, the P/E ratio of the stock market is situated around 16, and in the S & P 500 index, the avg PE ratio is around 30. Very high values ​​that many point to as a bubble of valuations. That this is a bubble is difficult to determine because there is also a circumstance never seen before: interest rates are practically zero and investors are able to take risk (invest in companies) even if the profitability is not very high that they will see a return on their investment.

Mechanisms and phases of a Bubble

There have been some suggestions in the past but they just do not fit well with the empirical evidence. The truth is that in some moments there is a positive feedback, that is, when something goes up exuberantly instead of having a compensation effect (for example, that the previous investors sell to secure their profits), everyone gets on the bandwagon.

There are also indications that access to easy and cheap credit causes bubbles.

What is certain is that the phases of a bubble are well defined. After an initial increase in prices due to real and well-founded factors, the rise attracts speculators (who do not have to be evil men dressed in black on Wall Street, it can be perfectly normal people who don’t want to be left out).

After this the rise begins to be exponential and those who point out that it can be a bubble are disqualified saying they do not understand anything, that it is a new paradigm, new economy or anything similar. Finally, the outbreak occurs, but not before the real experts sell their positions. And here those who were not professional speculators lose a lot of money.

Reasons why Bitcoin could be a bubble

First, because the climb is brutal. Such a large increase may be based on the fact that it will cause radical changes in society, but it must be remembered that other radical changes in society, such as the locomotive or the Internet, also experienced their bubbles. Although there was some foundation behind them obviously, the investment was excessive and irrational and left many investors bankrupt.

Second, because it has failures. Volatility does not allow it to be a means of payment, but a refuge value. And as a refuge value, it only has scarcity and trust. If you lose confidence, you can collapse very quickly. There are also some technical limitations, such as the energy consumption required to operate at current levels.

And third, because disqualifications similar to those of previous bubbles are heard lately: this is a paradigm shift, it is going to revolutionize the economic transactions, you do not really understand how it works etc…

And I tell everyone who asks me the same thing: I am convinced that Bitcoin is a financial bubble. In a bubble, you can earn a lot of money but also lose it, because nobody wants to be the first one to retire but when the music goes out it’s already too late.

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