Apr

3

Bubble might be the most overused term in finance. It seems that if any asset price goes up, somebody will say it is a bubble. I think of a bubble as being an event of extreme price increases accompanied by widespread behavior that would be considered irrational in normal times. As Eric Falkenstein pointed out in the excellent article cited below, fraud becomes rampant, too. Valuing money-losing Internet startups on eyeballs in 2000 was irrational in hindsight. So was giving $700,000 no-doc mortgages to anybody who showed up. The only comparably insane activity that I am aware of today is building whole cities of empty buildings in China.

"A Batesian Mimicry Explanation of Business Cycles"

[B]usiness cycles are best understood though the framework of Batesian mimicry, an endogenous mechanism for booms and busts thru a misallocation in the horizontal structure of production. In ecosystems, Batesian mimicry is typified by a situation where a harmless species (the mimic) evolves to imitate the warning signals of a harmful species (the model) directed at a common predator (the dupe). …

… In an expansion investors are constantly looking for better places to invest their capital, while entrepreneurs are always overconfident, hoping to get capital to fund their restless ambition. Sometimes, the investors (dupes) think a certain set of key characteristics are sufficient statistics of a quality investment because historically they were. Mimic entrepreneurs seize upon these key characteristics that will allow them to garner funds from the duped investors. The mimic entrepreneurs then have a classic option value, which however low in expected value to the investor, has positive value to the entrepreneur. The mimicry itself may involve conscious fraud, or it may be more benign, such as naïve hope that they will learn what works once they get their funding, or sincere delusion that the characteristics are the essence of the seemingly promising activity.

Gary Rogan writes: 

The thing about bubbles, they can only be definitively identified in retrospect when it's useless for any practical purposes. Is Facebook with P/E of 100, P/S of 20, and P/B of 10 a bubble? Is Facebook paying $19 Billion, more than 10% of its market cap for a company with $20 million in revenue a sign of a bubble?

anonymous adds: 

I have never understood the "only identified in hindsight" notion. I think I have been reasonably good at identifying bubbles. Most of the traders I have known, If I look back, i think have been decent at identifying bubbles. The real problem is that identifying bubbles has nothing to do with profiting off of them, and that creates confusion.

The real problem for those who want to call a "bubble" and benefit from it is that there is almost never a mechanism for arbitraging the situation other than by participating in, and thus perpetuating, the bubble. That is why it becomes a self-reinforcing process. People claim not to know things are not irrational because that is how one saves face or reputation after the music stops. Before the music stops, everyone hopes to be quick enough to find a seat.

To switch the topic, or perhaps an analogy, in Atlas Shrugged Rand had the heroes use a very interesting strategy to change the social order. Rather than "fighting" the system, they accelerated the system. That was a good strategy. I think this same type of ordering process occurs at times in financial markets. At times, the fastest way to end a bubble or pop a bubble is to accelerate its growth - the underlying process is too strong to fight or go against. 


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