The alchemy of a Bubble

Stories of Success


1 décembre 2022

Yesterday evening I received a call from a friend of mine in New York. The hot  topic: the market turmoil in the crypto world after the collapse of the FTX crypto  platform. Among the many details and anecdotes, one caught my attention:  my friend defined the event as the “Lehman Brothers of crypto”. That’s a huge statement. We all know the kind of havoc ignited by the bank’s collapse in 2008.  So, despite my deep detachment from the crypto dynamics, I decided that the time had come for further investigation.
So I wondered what is FTX?

FTX happens to be a centralized cryptocurrency exchange with revenues amounting to 1 USD billion in 2021. The platform allows users to trade innovative derivatives products such as futures, options, tokenized assets and stocks. The company – founded by the eclectic CEO Sam Bankman-Fried – was  valued 32 USD billion in 2021. It is now in liquidation.

A swift investigation on the internet surfaced interesting stories about the FTX platform and its founder. In 2020, Sam made the second largest donation to  President Joe Biden’s presidential campaign according to WSJ. Moreover, the platform attracted high-profile sports stars of the like of Tom Brady and Steven Curry. The American football quarterback champions acquired an undisclosed  equity stake into the company in 2021 alongside his ex-wife Giselle Bündchen, who was also nominated as FTX’s Head of Environmental and Social Initiatives.

The platform pledged to donate billions in charitable causes. Sports has also been at the center of FTX marketing efforts. In fact, the company struck a 210 USD million naming rights deal in the e-sports gaming industry and a 125 USD  million naming deal for Miami Heat Arena in the NBA.

To be fair, FTX was not the only company engaged in such marketing  efforts. Other platforms embarked  on the same initiative. took an ever bigger swing, committing 700 USD million for  twenty years’ worth of naming rights  for the Staples Center of the iconic La Lakers.

This of course reminded me of the  forgotten practice of the late 90s carried out during the frenzy of the  dot-com bubble. Naming a stadium  became a corporate curse in the heyday of the internet bubble as  many companies committed hundreds of millions of dollars to brand a stadium.

The now defunct CMGI agreed to pay 114 USD million for 15 years to call the  New England Patriots stadium “CMGI Field”. But the list goes on to include other companies such as PSiNet and Enron. Interesting, isn’t it?

The association between similar events 20 years apart and the strong connection  with the dot-com era motivates me to refresh the alchemy of a bubble.
The definition found on the dictionary mentions its natural characteristics as a thin sphere of liquid enclosing air or another gas but also the metaphoric practice  of referring to good or fortunate situation that is isolated from reality or unlikely  to last. In the financial literature definitions regarding a market bubble abounds.  Alan Greenspan defined a bubble as a swift loss of value of 30% to 40% in an  extremely narrow time frame. But despite as one would phrase it, bubbles are  economic and social events with a long history. I cannot help but recall one of the  greatest and most lucid examples of market bubbles chronicles, the masterpiece Extraordinary popular delusion and the madness of crowds written by Charles Mackay in 1841. The book recounts the tulip mania, the South-Sea and Mississippi bubbles, events which should be read by any fresh student.

Different eras and geographies have experienced the irrational exuberance of  a market bubble and the ill-fated aftermath. Despite the apparent many differences among the many history cases, there are some underlying dynamics which set the conditions and kindle the enthusiasm for a specific asset class. Charles P. Kindleberger discussed the life cycle of these major financial events  identifying five consequential steps: “displacement, overtrading, monetary expansion, revulsion and discredit”.

We agree that the initial spark for a bubble is what Kindleberger defines displacement, an event that triggers the initial blaze in a particular asset class.

It is worth noting that a displacement event could be of any form, policy responses  included. It could be a technological innovation like the advent of the internet or a major financial shock. In many cases one stimulates the other.

Many pundits see the oil shock in 1973, the Mexican debt crisis in 1982 and the collapse of Long-Term  Capital Management in 1998 as  unexpected events that prompted a policy response so strong that set  the ground for a bubble in a particular asset class.

In many cases monetary and fiscal expansion add to the equation, as easing has always been a response  to a situation of emergency.
Speculation is not possible until  money is either cheap, available  or both. A new technology could  emerge in a tight economic environment, but the real frenzy  begins when money abounds.

In 1998, the Russian debt crisis and the  ensuing collapse of LTCM threatened  the stability of the whole financial system. Central banks around the world lowered interest rates flooding  the market with liquidity that turned  a bull market into a moment of pure  madness.

However, any historical record pale  in comparison to the monetary and  fiscal response after the Covid crisis.  It should not come as a surprise that  the real bull run in the crypto asset  class began after March 2020. From  a low point in March 2020, Bitcoin returned 1259% until its peak in  November 2021. Ethereum did even  better since it returned 4251% in the  same time frame.

Another feature of bubbles is overtrading, an idea quite easy to  grasp. It usually refers to an abnormal  activity level in the reference market. True bubbles across ages have always seen a massive public  involvement. This is the distinctive characteristic of a true bubble.

Usually, the layman is induced in incessant activity by the belief that the price will rise further for an  extended period of time.

In the Dutch  tulip mania, what was once confined  to rich merchants became common practice among normal individuals,  which were willing to dispose of their properties to buy bulbs in the hope that someone else would come  along and pay even more. In the crypto world, the holding period is set in days, an indication that trading activity is rampant and the only purpose is to sell at always higher prices. Finance folks usually refer to this behavior as the “greater  fool theory”.

Revulsion takes some time to creep  into the mind of the investors.
At first sight, any drop is welcome as a “buying opportunity”. However,  recurring drops in value lower  investors’ confidence reducing their  hopes for a potential recovery. In April 2020, the NASDAǪ index fell  25% in one week,  a move heralded by many as “buy the dip”. As we came to know, that was a turning  point for the market that attracted many into a spiraling vortex.

Finally, discredit means that the once loved asset became unappealing for the  investment community. Ironically, this has proven to be the best time to buy a given asset class.

The stages here identified resembles quite closely the stages that any terminally  ill patient experience as they contemplate their mortality. All bubbles, like any other thing in nature, are finite. But any history is unique as it is shaped by place  and time.

Unfortunately, we cannot be absolutely sure if cryptos will be seen as another  market bubble in the making. Anyway, some symptoms point to the formation of  a market bubble. The extremely favorable policy responses dictated by the Covid  crisis ignited the narrative about the potential of a new technology capable of  redefining the global financial order. The ensuing mass participation alongside  excessive trading are the other major indicators of a bubble.

Moreover, there is another concept that should not be dismissed by anyone involved in the investment game. Investing involves paying a fair price to participate in the future cash flow of a company. Finance 101 courses teach to students that any instrument is worth the present value of all the future streams  discounted back at an appropriate interest rate. In this regard, the concept of terminal value is fundamental in the investment world.

Despite its ephemeral concept, the notion has real application and strong implication for the likely development of markets. When an asset is discounting  any potential stream from now to infinity, it is usually said that the asset is priced  for perception. Not a secure spot for an investor as it raises the risk of future disillusionment.

Going back to crypto – experts forgive us – we were unable to come up with a rational method of establishing potential future  streams of income. Thus, any evaluation method was practically impossible. I am not saying that there is no value, technology has its merit but current situation and market valuations should be taken with a grain of salt. In our opinion, prices are more than priced for perfection. The underlying dynamics of the ecosystem – not really transparent – coupled with the bubbles’ red flags discussed above make this asset class definitely not in our realm. We did not invest in crypto, we do not except to do so  for the time being.

It is fascinating how any era has its own myths and fads. New generations – unshaken by previous events – tend to rewrite the rules of investing just to discover at their expense that it is not different this time. Call it turnpikes, tulip, South Sea, Mississippi or dot-com, any generation has had its own dose of craziness. For unknown reasons investors keep on behaving  like each cycle is new and unique, exempt from the rules of the market. As we have seen there are anyway some conditions that makes a bubble likely. One of them – extreme largeness in the monetary and fiscal policies – has been one of the recurrent themes among all bubbles.

This fertile environment coupled with disruptive innovation has periodically driven the mass public into a market frenzy.
We cannot know with absolute certainty if crypto will be just another name to add to the list of market bubbles. We are not  betting in any direction but clues are mounting for another mania. Time will tell.
In the meantime a question remains unanswered: If this is really a Lehman Brothers moment, who is going to save them?

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