The Anatomy Of A Bubble

Written by Craig Basinger, Chris Kerlow, Derek Benedet, Shane Obata – RichardsonGMP 

Stock market bubbles don’t grow out of thin air. They have a solid basis in reality, but reality as distorted by misconception. – George Soros

With the rapid rise of the price of bitcoin and other crypto currencies, the talk of bubbles has, well, bubbled to the surface. The only thing that has risen faster than bitcoin is the Google searches for ‘bitcoin’. Without passing any judgement on bitcoin’s next move, either higher or lower, we thought it might be insightful to take a look at past bubbles. This ‘anatomy of a bubble’ will look at common ingredients of environments that foster bubbles, how they inflate, their various stages and, of course, how they inevitably pop. There are many commonalities across different bubbles, but there are also differences. Begging the question, just what kind of bubble is bitcoin?

Nobel Laureate, and author of Irrational Exuberance Robert Shiller defined a bubble as “a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a larger and larger class of investors … despite doubts about the real value of an investment.” Bringing in the idea of a positive feedback loop certainly helps explain how prices reach exuberant levels. Feedback loops and other behavioural mistakes are critical components in every bubble in history, and it does show just how far things can go.

The Bubble Roadmap

We thought providing a generalized roadmap to a bubble may help investors understand how these develop. Dr. Jean-Paul Rodrigue from Hofstra University is the source of Chart 1 that provides a very neat and tidy map for the various stages and the path of a bubble. While every bubble doesn’t follow this path perfectly, it does capture many of the similarities across various bubbles over the past few centuries. It really does a great job at showing how knowledge of a bubble spreads across different kinds of investors over time from a few pioneers, to smart money, to general investors and then finally to just about everyone. Hint: if your Uber driver has brought up bitcoin, you may know where we are in the chart.