Are We In A Bubble?

Well, the answer is yes. 

A slew of reputable investors have come out to say we are in a bubble. When I say reputable, we are not even talking about David Einhorn or Dan Loeb. Here's market veteran Jeremy Grantham who has studied bubbles over 50 years and he is telling us, we are in a bubble and this may become the biggest bubble we have seen.

https://www.gmo.com/asia/research-library/waiting-for-the-last-dance/

There are a few characteristics about bubbles. First it is when valuations are inexplicable. Look at Tesla.

Tesla's share price

We discussed this before. This company has never made money for shareholders. It produces less than 500,000 cars and yet it is now bigger than almost all of the global automakers combined. In a bubble, it is easy to just look at the stock price. Nothing else really matters. Dividends, accident and safety record, resale value. Well, who's tracking anyways. People who bought Tesla look like heroes. Most would not have done thorough analysis but who cares. They made a lot of money and Elon Musk is their god. 

The second characteristic is about people. We know we are in a bubble when everyone is crazy about stock markets. In the past, it was when grandmothers ask for stock tips. This time, it is exhibited over the social media. It started a few years with bitcoin. Remember ICOs? Then Robinhood allowed account holders to buy bitcoins. Bitcoin is now back with a vengeance. 

Bitcoin's twin peaks

The other day, my friend asked over social media whether it is a good idea to invest in bitcoin. He had already bought and he was seeking confirmation whether it was the right decision. I did not have the heart to tell him he was playing with fire. Sure, there is money to be made. Who knows if bitcoin can hit $100,000? That will be more than 100% upside from here. But it is impossible to predict. The party could end in a few months and bitcoin could be back at $4,000.

In the earlier bitcoin bubble during 2017-2018 when ICOs became the craze and soon got into issues, it was a similar situation. The same hyperbolic chart (above) and the same likelihood things can go really wrong. It did crash and burn. But few would have seen it coming back in two years and becoming so much bigger. Deja vu at its best!

The last characteristic relates to compounding and hyperbolic charts. Stock markets over time follow compounding charts and not hyperbolic charts. It is very subtle but important. All investors should understand this.  The chart below shows Nasdaq. As with bitcoin, it went hyperbolic in 1999 and it is going hyperbolic now. When that happens, it has to crash. We just don't know when. It can last another year, or two or even three but it cannot go hyperbolic forever.

Nasdaq over 50 years

The next chart shows how healthy compounding looks like. Costco is the best retailer in the world. It gives customers a value proposition by selling things cheap in bulk. This discount is passed on to its customers who pay an annual membership fee. It is said that Costco is simply earning membership fees because it sells products at cost to its members. But because Costco provides such a strong value proposition, it compounds. It has done so over 40 years and will continue to compound healthily. No bubble here.

Costco since 1980s

As you can see, the difference is very subtle. The Costco chart and the Nasdaq chart differs only during 1999 and maybe today. When we stretch out the x-axis over time, the Nasdaq bubble in 1999 does not seem so bubblish. Over time, like 40-50 years, it becomes a blip. But people who rode it up in 1999 and failed to get out lost their shirts. Today feels like 1999. We don't want that to happen to us.

There is a natural order to growth. A bubble grows by sucking everyone to buy in a very short time and money eventually runs out. Costco grows its earnings slowly, providing value proposition to consumers. It will continue to grow steadily until every single household in the world becomes its member and even then, it can continue to increase its product mix, continuing to provide value.

Bubbles are not about providing value, it is feeding on people's fear and greed. The fear of missing out and the greed to make a quick buck. Hence, bubbles always burst. We may be in the biggest one ever. Let's be really careful in 2021. 

In the next post, we will explore a bit more about this pandemic bubble.