• Rollercoasters are fun, asset bubbles are not
  • What inflates up, must pop down
  • Some investors know how to play a bubble

Since the days of the Tulip Bubble, the South Sea Bubble and the Mississippi Bubble, speculators have had a bad name. Irrational exuberance causes them to bid market prices up to dangerous levels, before they come crashing back down again to ruin those who bought in too late.

When the dust settles, you’re left with people who got rich by luck, or in more questionable ways, and those who unfairly lost their life savings by being too late.

Depending on whom you ask, capitalism needs either guardrails or guiderails to prevent such chaos from constantly erupting. After all, nothing about the boom and bust cycle in asset prices featured productive economic activity. It was all just wild speculation – a zero sum game that enriched some at the expense of others.

In many cases, the bubble caused misleading price signals across the economy, wreaking havoc well outside of market prices and well beyond the pockets of investors. Sometimes a banking panic is triggered or government bond markets are destabilised. But the free market always gets the blame.

This narrative carefully evades some rather intriguing facts about those bubbles. Where did the money come from? Who set up and orchestrated those schemes? Why were people treating market asset prices as a get-rich-quick scheme in the first place? What made people believe prices could only go up?

But let’s take the premise as true: financial markets are inherently inclined toward inflating and popping speculative bubbles. They boom and they bust, taking investors with them on one heck of rollercoaster.

What are the implications for investors who don’t want to be taken for a ride?

Lots of different investment gurus have lots of different responses to how you should deal with bubbles. Some choose to ignore whatever is fashionable. Others invest for income instead of capital gains to avoid the “get rich quick” schemes.

I vividly remember the prolific investment writer John Mauldin praying in front of a large audience in Vancouver: “Dear God, please, just once, let me invest at the beginning of a bubble!”

The trouble is, even if John’s wish were granted by God or some other broker, his careful investment strategy would lead him to sell out far too early, when prices had barely begun to get detached from the fundamentals.

In a bubble, prices soar far beyond anything that makes sense and for much longer than anyone can predict. It doesn’t make sense, that’s the point. And only those who understand how absurd things can get manage to hold on long enough to walk away with all the gains.

That means investing in bubbles successfully requires understanding what makes them tick. Unfortunately, those who do understand the dynamics of bubbles tend to be preachers warning in sermon-like analysis against embarking on the dangerous fool’s errand of having a bubble in the first place.

After all, they don’t just happen, they are caused by something. And the devastation they leave behind is so painful that we should stop causing the bubbles.

Ludwig von Mises and Friedrich Hayek are two good examples of this. They weren’t speculators who got rich betting on bubbles. They tried to explain why they occur and how to avoid having them in the first place.

The Austrians, as they’ve become known, believed asset bubbles are caused by central bankers fiddling with interest rates and the money supply. Lower interest rates goose asset prices higher.

And if you believe central banks want to avoid a financial market panic from falling asset prices, that implies they will keep on cutting interest rates to keep on goosing asset prices ever higher. It’s a safe one-way bet – the context of every investment bubble in history and the source of investor’s speculative exuberance. “Stocks only go up” is the modern mantra. It comes from a belief in the central bank put – a promise to pump money into flagging markets.

But bubbles eventually burst because central bankers’ manipulation of money is an illusion. It doesn’t change reality on the ground. Prices eventually come crashing back down to earth.

Because house prices are especially interest rate sensitive, bubbles frequently form in the housing market, like in 2007.

Because stocks that aren’t profitable and don’t pay dividends benefit disproportionately from lower interest rates, it’s in the tech sector that we are likely to see a stock market bubble.

Because the green energy sector needs a lot of debt to finance its vast construction expense, it’s disproportionately likely to inflate into a bubble during low interest rates that pops when rates rise.

These are some of the dynamics of bubbles as we’ve come to know them. In fact, they’ve come to dominate our understanding of financial markets, with most returns over the past few decades driven by participating in and escaping bubbles before they burst.

Thanks to their importance, a small group of speculators have come to specialise in the topic.

There are some investors who know how to play asset bubbles

Investors have become so accustomed to bubbles that they now believe it’s the norm. And that they’re the key way to get ahead in financial markets.

At any one time, there is a dominant narrative behind what part of the market is moving. And we all pile in, hoping to be at the beginning of a bubble. We all know it’ll pop eventually. But it’s like a game of Old Maid.

There are two ways to play the game. One is to be so diversified that you are guaranteed to have at least a little money in the right sector at any point in time. The other option is to try and pick what booms next.

The thing is, some are better at the game than others. Those who understand the importance of being early in a sector that has the potential for a bubble, those who use Austrian-style analysis to identify when the time is ripe for a bubble to inflate, those who use dynamics beyond fundamentals to decide when to sell, and those who have the discipline to avoid entering a sector too late can maximise their gains.

Right now, two investors who specialise in this sort of analysis, and who have a track record of executing the strategy in assets like cryptocurrencies and tech stocks, have a message for you about the next big investment bubble.

Until next time,

Nick Hubble
Editor, Fortune & Freedom