Ok, so. Up until this year, I would’ve told you that there are two general kinds of financial bubbles. The first kind of bubble is where everyone believes the future will be like the present.
Think credit bubbles and real estate; think 2007-2008, where the fundamental belief that drove the bubble forward and into ruin was “We’ve figured this out. We can’t lose. The risk has all been worked out. Lever up, cowboy. We will never die.”
Obviously we’re going to talk about this today:
There are two reflexive feedback loops at work here.
The first is the positive feedback cycle between that belief, “We have the future figured out”, and rising asset prices – which confirm the invincible mentality and drive it forward.
The second loop is that rising asset prices translate to lower cost of capital. In a mindset like this, we get excessively comfortable with investing that low-cost capital into businesses and investments that generate predictable future earnings, or the illusion of predictable.
That cheap capital can then meaningfully contribute to those earnings actually materializing, on schedule.
Bubbles can genuinely be self-fulfilling prophecies; to a point. Past that point it’s bad.
The second kind of bubble is where everyone believes the future will be different from the present.
Think equity bubbles, startups, and crypto; think 1999, where the fundamental belief that drove the bubble forward and into ruin was
“It’s a new economy. All the rules are different. The upside is unlimited. If you get in now, you’ll be rich. We’re going to live forever.”
As before, there are reflexive feedback loops at work here too. The first loop is the positive feedback cycle between that belief, “I’ve seen the future, and I believe”, and rising asset prices – which confirm the bubble mentality, and bring on the FOMO.
The second loop, as before, is that rising asset prices actually do something useful here. It means we can fund cool startups!
Wacky, speculative ventures, which under normal circumstances could never raise any money, are able to access capital at attractive valuations.
Sometimes they do, in fact, build the future. These kinds of bubbles can be actually good.
Unlike before, where we rewarded predictable earnings (or, the perception of them) with low cost of capital, here it’s the opposite.
We’re looking for unpredictable earnings; specifically, the prospect of unknowable but infinitely high upside.
These bubbles can also become self-fulfilling prophecies (dot com speculation got us Amazon, and a whole lot of broadband cable), but they blow up when expectations get too detached from reality.
There are certainly sub-categories and variations on these two themes.
For instance, one driving factor you often see associated with bubbles is new financial instruments that give the retail buying public better access (or more aggressive leverage) to the object of speculation.
Crypto is an obvious recent example, but this goes all the way back to the Mississippi Company and South Sea manias, with the invention of the joint stock company and the bubbles that resulted.
Other stuff matters too, like economic cycles and political narratives.
But in general, up until this year, I would’ve told you that these are the two basic kinds of bubbles. I was wrong.
There is a third kind of bubble, and it’s happening spectacularly right now.
If the first kind of bubble is “everyone thinks the future will be the same”, and the second kind is “everyone thinks the future will be different”, the third kind is “everyone thinks the future doesn’t matter.”
If you remember, the 1999 bubble had a lot to do with technology and the future, sure, but also had something to do with boomers and early Gen Xers having all of this disposable money right as online brokerages became a thing.
Right now, there’s a similar thing going on. Millennials have real paychecks to spend, and stock trading fees have all gone to zero.
Trading has become gaming.