What are the signs of a bubble?
Economic bubbles have always been a hazard for traders and though each has been different, there is always a steep run-up in prices followed by a sharp fall.
However, a fast rise in prices on its own isn’t necessarily a sign that a market is in a bubble, since such a move may be justified by market fundamentals. So how can you tell when one is forming?
There are twi main signs traders and market watchers look for, with examples from the dot-com bubble:
A departure from conventional means of valuations
In the mid to the late 1990s, the market didn’t just wake up to the disruptive potential of the internet; it got completely swept up in it. Market participants started to believe that it wasn’t a company’s earnings that mattered, it was its potential. In other words, it didn’t matter that companies were hugely over-valued according to any conventional means because the conventional means of valuation no longer applied. The NASDAQ reached a price-earnings ratio of 107 at the height of the tech bubble, meaning it would have taken more than a century for the companies listed on it to earn back their valuations. Note that while a buy and hold investor who bought Amazon stock with this attitude would have done very well for themselves, most stocks went bust and even established players like Cisco lost 80% of their valuation.
An increasingly steep rise in prices
It took more than 1000 days for the NASDAQ to rise from 1000 to 2000 points, but only 475 days to then hit 3000 points. After that, it took just 56 days to reach 4000 points and a further 71 to surpass 5000 points – rising far more quickly than the earnings of the companies listed on the exchange.
Why is the crypto market more susceptible to bubbles?
Unlike conventional markets, crypto assets cannot be valued through conventional means. Stocks, for instance, can be valued by looking at a company’s sales or earnings (among other criteria). Forex traders can look at a country’s interest rates and economic data and commodities traders can look at real-world supply-and-demand dynamics. But crypto traders have little to look at beyond the activity on the market itself.
In addition, one of the core ideas driving investment in cryptocurrencies is that these assets, or at least their underlying technology will revolutionise the world of finance. In fact, many supporters go much further and predict cryptos will replace fiat currencies. By definition, the belief is cryptos are different to other assets. Whether this view turns out to be right or wrong, it adds to the potential for bubbles to form.
Has the crypto market learnt anything from past bubbles?
Having just been through a huge bubble undoubtedly reduces the risk of another bubble forming, at least for a while.
The Bitcoin price has rebounded considerably from its lows and while there is still a lot of enthusiasm for the crypto market, there has been no return to the mania of 2017. Many traders who were burnt in the crash will have learned from the lessons while the size of the recent fall would likely deter some traders and investors from entering the market.
However, that’s not to say crypto prices will stagnate either. It is extremely likely this will remain a volatile market for some time to come.
Given the boom and bust cycle Bitcoin has followed over the past decade, the risk of another bubble forming remains high.
What does the future hold for cryptos?
The fact cryptocurrencies cannot be valued through conventional means will always put the market at greater risk of bubbles than asset classes like stocks or commodities.
However, supporters would point to the fact that despite weathering several bubbles, Bitcoin’s price has grown from virtually nothing to thousands of dollars within a decade.
It remains a highly volatile investment with vocal supporters and opponents and many watching on with keen interest.
