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Market Bubbles and Recovering from a Crash

Sep 10, 2021 10:31:12 AM

Market Bubbles and Recovering from a Crash

So what did we learn from the recent Cryptocurrency market bubble?

Nothing – in short.

Nothing we did not already know...

The first thing to understand is that cryptocurrency is not the first bubble market and won’t be the last.

History repeats itself. As long as there are market participants engaging in the free trade of an asset – financial bubbles will inevitably ensue – some fortunes made with many more lost

A brief history of some notable financial bubbles is below…

Japan’s bubble was characterized by a rapid acceleration of real estate prices (and subsequently stock prices) and an overheated economy. All of this was fuelled by a Bank of Japan monetary policy error, lowering interest rates and allowing uncontrolled money supply and credit expansion. The euphoria phase was characterized by Japanese citizens, traditionally great deposit savers, shifting money from savings accounts into the capital market.[4]

Picture 1-1

*Eerie similarities between the Japanese Asset Price bubble and the current US and Australian Economy – I will examine this more closely in my next article on Modern Monetary Theory

Here are the 5 stages of financial bubbles every investor should familiarise themselves whether they knowingly or unknowingly decide to participate in the next one:

Stage 1. Displacement

An event or innovation occurs that sharply changes expectations. This phase is typically grounded in reality and good intentions.

The idea for distributed digital scarcity-based cryptocurrency was genesised in the 1990s by Chinese computer engineer Wei Dei. This idea was refined and some say mastered on 18 august 2008 by Satoshi Nakamoto with the mining of this bitcoin block.

The genesis block of bitcoin ledger read: The Times Jan/03/2009 Chancellor on brink of second bailout for banks

The time-stamped quotation of the Times headline and an ode to the quintessence of bitcoin – a decentralised alternative to the current central banking system.

A well-intended sentiment which in time would only grow in popularity over the next decade.

Stage 2. Boom

Prices rise slowly at first, following a displacement, but then gain momentum as more and more participants enter the market, setting the stage for the boom phase. During this phase, the asset in question attracts widespread media coverage. Fear of missing out on what could be a once-in-a-lifetime opportunity spurs more speculation, drawing an increasing number of investors and traders into the fold.

Stage 3. Euphoria

Valuations reach extreme levels during this phase as new valuation measures and metrics are touted to justify the relentless rise, and the "greater fool" theory—the idea that no matter how prices go, there will always be a market of buyers willing to pay more—plays out everywhere.

Common for investors to disregard investment strategies and submit to the hype where high valuations are perceived as asset success which is a misnomer.

Many crypto investors telling themselves in 2021 “this time it’s different”…

Stage 4. Profit-Taking

The smart money begins heeding the warning signs and is selling positions to take profits.

Stage 5. Panic

Reality sets in, investors panic, and prices reverse course and descend faster than they increased.

Why do bubbles happen…

I could take this opportunity to dump an excessive amount of academic research as to why financial bubbles occur- referring to the different types of behavioural and cognitive biases which drive them.

However, I would much rather impart a concise explanation of market bubbles from Warren Buffet followed by some practical steps on how an everyday investor can survive the next one…

"People start being interested in something because it's going up, not because they understand it or anything else. But the guy next door, who they know is dumber than they are, is getting rich and they aren't," he said. "And their spouse is saying can't you figure it out too? It is so contagious. So that's a permanent part of the system."[5] -Warren Buffett October 1, 2008…

Key Lessons to Learn from the Crypto Bubble:

  1. Risk-weighted Asset Allocation

The foundation to successful investments is diversification – not just across asset classes but across risk profiles also.

Conservative investments such as property, bonds, Bluechip stocks, should always make the majority of anyone’s portfolio.

Even our managed investments – like our Swing Strategy – which is although high-performing, should only be a 10% allocation of the client’s portfolio due to its assertiveness.

Even I could not ignore the potential for high return in the cryptocurrencies earlier this year – and when many of my clients discussed it as a potential investment I simply told them ‘no more than 1% allocation of your portfolio or only as much as you’re a prepared to lose’.

  1. Avoid Getting-even-itis!

Loss aversions are the tendency of investors to NOT cut losses short, and instead, hold on to losing investments until they can be sold at the break-even price paid for it. This happens because realizing a loss is painful, while it’s easy to feel good about selling something a gain. [6]

An observed continuation of loss aversions is the tendency to increase in an attempt to get even with the market.

There is a temptation for investors who were scorned by the recent crypto crash to chase their losses and take start making wild speculative investments in an attempt to recover their lost monies.

It is vital the investor avoid getting-even-it is making an immediate transition or return to more sustainable investing.

To find out more about Walker Capital’s Managed Investment please schedule a time with one of our staff.

[1] https://www.history.com/news/tulip-mania-financial-crash-holland

[2] https://www.historic-uk.com/HistoryUK/HistoryofEngland/South-Sea-Bubble/

[3] https://www.focus-economics.com/blog/railway-mania-the-largest-speculative-bubble-you-never-heard-of

[4] https://www.investopedia.com/articles/personal-finance/062315/five-largest-asset-bubbles-history.asp

[5] https://www.cnbc.com/id/26982338

[6] https://www.nngroup.com/articles/prospect-theory/

Cryptocurrency | 5 MIN READ

Why Cryptocurrency will never work…

Sep 10, 2021 10:16:44 AM

Why Cryptocurrency will never work…

When the price of something goes up and up, not because of its intrinsic value, but because people who buy it merely do so with the expectation to be able to sell it again at a profit – what is known as The Greater Fool Theory[1] – that is to say its price is solely determined by speculation and confidence… it never ends well.

When this Greater Fool Theory effect is coupled with a mass infection of confirmation bias – that is investors convince themselves intrinsic value is much higher than it is – financial bubbles tend to follow.

Bitcoin continued to sell off this week down to $35,688 USD currently which is nearly 50% less than its all-time high of $64,863.10 only 6 weeks ago.

We hold the belief it will get a lot lower in the weeks and months to come and here’s why…

The main criticism of cryptocurrency – other than price discovery – is its inadequateness to serve the 3 main purposes of currency

3 properties of currency:

  1. Store of Value

Maintains its value over time[2]

The speculative forces which underpin cryptocurrency make it probably the most unstable asset we have ever seen. To be an effective store of value a currency’s volatility must be such that it does not cause significant deviations in its purchasing power.

…Strike #1 for BTC

  1. Unit of Account

A standard unit of numerical measurement of the market value of goods, services & other transactions.[3]

Cryptos do provide a standard unit of measurement, offering exchange rates for USD and other cryptos – however, due to the instability of their prices, it makes the practicality of trading goods and services with cryptocurrency impossible.

Strike #1 and a half

  1. Medium of exchange

Can be used to intermediate the exchange of goods or services[4]

I do not doubt that blockchain technology has its place to be an effective utility in the future. However, as a currency, it will never replace any of our current reserve currencies until it better serves the aforementioned properties.

So, as we can see the inhibiting factor preventing cryptocurrencies, like bitcoin, from being adopted as world reserve currency stems predominantly from its excessive volatility.

The following needs to take place to suppress crypto volatility:

Targeted Price Range

Let’s use BTC as an example as it pertains to trade: The largest participants in the currency markets are countries and large MNC’s who deal in cross border trade which create a need to exchange one currency for another.

For a company or country to exchange in BTC for their goods or even their own currency, they would need to have confidence in the stability of the BTC to use it as a medium of exchange.

In order to stabilise BTC the supply of BTC will need to be controlled by a central body so that the central body could increase and decrease the supply as needed to stabilise price within a targeted range and give market participants confidence to use BTC as a medium exchange (same can be said as a store of value)


Furthermore, the central body regulating the supply of BTC will need to be an independent body that must not only ensure the price stability of BTC but also must make inflationary considerations when adjusting the supply of BTC.

As oversupplying BTC to the market could lead to inflationary pressures…

Who said Decentralised was a good thing for a currency?

Essentially, BTC rode the curtails of an anti-establishment movement which started with many being disenfranchised and discontent with the accommodating nature with which the central banks bailed out the greedy commercial and investments bank during the GFC.

The genesis block of bitcoin ledger written by Satoshi Nakamoto read: The Times Jan/03/2009 Chancellor on brink of second bailout for banks

The time-stamped quotation of the Times headline and an ode to the quintessence of bitcoin – a decentralised alternative to the current central banking system.

What Satoshi failed to realise is that currency must be centralised so that its supply can be regulated and its price stable for it to be effective.

So, Bitcoin deluders can shout ‘Power to the People’ all they want whilst preaching the benefits of decentralisation but the reality is that decentralisation is the antithesis of an effective currency.

Blockchain – not currency

Blockchain technology and smart contracts are truly innovative as a type of business improvement software. Collaborative technology, such as blockchain, promises the ability to improve the business processes that occur between companies, radically lowering the “cost of trust.”[5]

PwC conducted an explorative dissertation on all its potential uses – found here

Blockchain is the technology which allowed allows cryptocurrencies – like BTC – to exist.

The idea for distributed digital scarcity-based cryptocurrency was genesised in the 1990s by Chinese computer engineer Wei Dei. This idea was refined and some say mastered on 18 august 2008 by Satoshi Nakamoto with the mining of this bitcoin block.

Bitcoin hijacked a good technology with real practical uses in an effort to create money from nothing…and people bought it mistaking increasing price as an indication of successful asset performance.

[1] https://www.investopedia.com/terms/g/greaterfooltheory.asp

[2] http://money.visualcapitalist.com/infographic-the-properties-of-money/

[3] http://money.visualcapitalist.com/infographic-the-properties-of-money/

[4] http://money.visualcapitalist.com/infographic-the-properties-of-money/

[5} https://www.pwc.com/us/en/industries/financial-services/fintech/bitcoin-blockchain-cryptocurrency.html

Cryptocurrency | 5 MIN READ

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