Yesterday Bitcoin surpassed the magical figure of $10,000 for the first time. This takes the price increase of the cryptocurrency over 1,000% this year. That means that Bitcoin has increased in value by over 10 times since last December.
The optimism and enthusiasm that has captured investors’ imagination is bringing the ‘crypto asset’ to the mainstream despite mounting warnings that this is all a bubble. To be fair, towards the end of 2017, it is increasingly hard to find markets that are not in bubble territory.
And while Bitcoin is testing the limits of this much feared concept other more ‘mundane’ markets cannot shy away from the fact that they are well past any realistic and sensible peak. The bond market for instance; the coupon that is received should at the very least cover the average market credit loss rate. Still the Market iBoxx EUR Liquid High Yield Index currently yields 3.7% which just barely covers high yield risks as determined by Moody’s data between 1920 and 2008.
Similarly, The S&P 500 has been going through the current bull market since 2009 and during this period the index has gained 288 percent, or an average of 40 percent annually. So the argument is whether bitcoin is just the showcase of an exceptional period characterised by asset inflation or just a coincidence.
What is an asset bubble?
Bubbles are created by a surge in asset prices way past what can be reasonably explained by fundamentals. This is often complimented by exuberant behaviour by market players and ends when no more investors are willing to buy at the elevated price, a massive selloff typically follows, causing the bubble to burst.
A basic characteristic of bubbles is the suspension of common sense by most investors during the bubble build up. Amateur investors will join the prevailing trend with unrealistic expectations, and experienced investors will tend to ignore valuation techniques to justify investment. In the end both will be losers.
Economist Hyman P. Minsky’s work on financial instability attracted little attention prior to the financial crisis of 2008-2009. However, today it is considered a pioneering work on the subject. In his paper ‘Stabilizing and Unstable Economy’ (1986), Minsky outlined 5 steps of a Bubble;
1. Displacement: A displacement occurs when investors became fixated with a shift in investment paradigm. This may be a technological innovation or interest rates that are historically low.
2. Boom: Prices rise slowly at first, but then gain momentum as more and more participants enter the market. Typical characteristics of this phase are an increase in media attention, fear of missing out by investors and increasing number of participants.
3. Euphoria: Caution is thrown to the wind and asset prices skyrocket, valuations reach extreme levels. During this phase established valuation methods are replaced by ‘innovative’ methods that seem to explain the asset prices.
4. Profit taking: Smart money starts to heed the warning signs and start selling out positions and taking profits. However, it is extremely difficult to call the peak of a bubble which can be extended by months or even years.
5. Panic: Asset prices reverse course and descend as rapidly as they had ascended. Investors faced with plunging values now try to liquidate at any price. Leveraged investors are worst off as falling values fail to cover debts. The slide is sharpens as supply overwhelms demand.
Therefore, while it is anyone’s guess whether markets are in bubble territory, caution must always be a primary consideration. Good portfolio management is not about managing your potential gains but about managing your potential loses.
This article was issued by Antoine Briffa, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt . The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.