The Term Bubble is Way Overused

The Bubblicious Financial World

Bubblicious

by Greg Harmon, Dragonfly Capital

Bubble is the latest favorite word in the financial press. Seems everything is in a bubble now from watching ten minutes of financial ‘news’. Bonds are in a bubble, stocks are in a bubble, housing is in a bubble. I am sure I have missed some assets classes but that was all I could take before turning the sound off again. I know a couple of things about bubbles. At my house Rainbow Looms are definitely in bubble mode. Each kid has 10 on each arm, I am wearing 2 and we are sending them to our cousins and grandparents in the mail. Bubble right? Well that is how everyone describes bubbles. A rapid rise in activity with he expectation that it is not sustainable. The problem is that I have seen 20 of the last 2 bubbles in stocks and housing predicted. It is hard to do. But with geniuses like John Paulson making billions and becoming famous for these predictions how can you not call a bubble. What if you are right? There is a lot of upside. The problem with all the bubble calls is that is very hard to be right. From Investopedia my emphasis added:

An economic bubble (sometimes referred to as a speculative bubble, a market bubble, a price bubble, a financial bubble, a speculative mania or a balloon) is “trade in high volumes at prices that are considerably at variance with intrinsic values”. It could also be described as a situation in which asset prices appear to be based on implausible or inconsistent views about the future.

Because it is often difficult to observe intrinsic values in real-life markets, bubbles are often conclusively identified only in retrospect, when a sudden drop in prices appears. Such a drop is known as a crash or a bubble burst. Both the boom and the burst phases of the bubble are examples of a positive feedback mechanism, in contrast to the negative feedback mechanism that determines the equilibrium price under normal market circumstances. Prices in an economic bubble can fluctuate erratically, and become impossible to predict from supply and demand alone.

If you had a time machine then calling bubbles would be easy. As a student of price action I have 2 comments for the current round of bubble callers. First, one aspect that seems often to be paired with each call is that the asset group is over bought or gone too far too fast. Observation of price action would tell the bubble caller that this excess enthusiasm can resolve itself with falling prices, a burst of a bubble. But it can also resolve through time, digesting the recent price action. Second, an asset or market as a whole can remain irrationally valued much longer than you can predict. Put another way, markets can remain irrational longer than you can remain solvent.

Every market that is rising quickly is not a bubble. And any market that has rising for a long time and is not falling (bonds) is also not necessarily a bubble. They could be but you will never know ahead of time. Instead why not just continue to follow the existing trends and not worry about bubbles. The markets will let you know if they are too high.

Copyright © Dragonfly Capital

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