Investing In Bubbles

[This post is an excerpt from a recent TSI commentary]

Many assets show signs of being immersed in bubbles right now. The most obvious example is the cryptocurrency speculation, which includes Bitcoin, the numerous and rapidly-multiplying Bitcoin alternatives and, more recently, the stocks that are involved in cryptocurrency ‘mining’. Other examples are the broad US stock market, the stocks of companies involved in social media and/or e-commerce, the market for junk bonds, and a group of junior mining stocks where just the hint of a possible discovery has led to spectacular price gains and market capitalisations that bear no resemblance to current reality.

The most enthusiastic participants in each bubble believe that although bubbles exist elsewhere, there is a special set of circumstances that justifies the seemingly high valuations in the asset that they happen to like. For example, many of the cryptocurrency enthusiasts believe that the US stock market’s valuation doesn’t make sense but that Bitcoin’s valuation does, and many stock-market bulls believe that the S&P500?s current level is justified whereas Bitcoin’s valuation is ridiculous. However, the bubbles are all related in that they all stem from the returns on conservative investments having been driven to near zero by the actions of central banks.

Now, just because an asset is immersed in an investment bubble doesn’t mean that it should be avoided. Buying something after it enters bubble territory can be very profitable, because huge gains will often occur AFTER valuation reaches a point where it no longer makes sense to a level-headed investor. The problem is, if you ‘know’ that a particular asset is immersed in a bubble then you will be constantly on the lookout for evidence that the bubble has ended and that the inevitable implosion has begun. In effect, you will constantly have one foot out the door and will be acutely vulnerable to being shaken out of your position in response to a normal correction.