Traders work on the floor at the NYSE.Brendan McDermid/Reuters
The word “bubble” has been bandied around for a few years now. The b-word has been linked to bitcoin, private equity (backlog of businesses for sale), private debt (redemption problems), and of course, the AI buildout. There’s nothing yet to show for all the buzz, but the word continues to be well used.
As the debates come and go, it’s useful to distinguish between the types of bubbles. In their book, Boom: Bubbles and the End of Stagnation, Byrne Hobart and Tobias Huber suggest two: Inflection bubbles and mean-reverting bubbles.
The former are all about changing the world. They’re driven by science and technology, and contemplate something that’s never been done before.
Innovation-driven bubbles are not frivolous. They’re based on something that’s real and impactful, but also totally new, which means there’s no precedent limiting investors’ imagination.
Mr. Hobart and Mr. Huber, among others, argue that inflection bubbles can be positive, saying they’re “important catalysts for techno-scientific progress.” To stimulate true breakthroughs, unbridled enthusiasm and “bad investing” are essential, they say.
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AI definitely fits this category. Excitement and a massive flow of speculative capital have allowed for advancements that might have otherwise taken decades.
Mean-reverting bubbles aren’t making such grandiose claims. They’re investments that promise more return with less risk by being better at what already exists and using more leverage than previously thought prudent. The U.S. subprime mortgage bubble in the early 2000s is a good example. When it burst, there was tremendous wealth destruction with no human advancement to show for it.
If private debt and equity turn out to be bubbles, they would fit this category. Both are deemed to be better ways to do something that’s been done for centuries – own and lend to businesses.
We won’t know until after the fact whether AI or private assets are impending bubbles. We can, however, explore what needs to be present for a pinprick to deflate dreams, egos and stock prices.
Prices rise rapidly to unforeseen heights
It’s a powerful, seemingly unstoppable trend that goes on longer and achieves greater heights than anyone could have anticipated.
Lopsided consensus
People are very confident about what’s going to happen. A range of possible outcomes, each with a probability attached, narrows to a single scenario (probability: 100 per cent). Uncertainties become assumptions. Questions and doubts are quickly steamrolled. “Worship” is not too strong a word to describe the emotional attachment to the consensus view.
Good at any price
Bubbles are about narrative and emotion, not numbers. The math goes out the window. People have to own it, no matter what the price.
As a consequence, extreme valuations are present in every bubble. So much so that when calculations are done to justify purchase, they’re quite comical. Analysts’ models extrapolate the current pace of growth far into the future to show that the stock will trade at a more relatable multiple 10 years hence. (I should note that a handful of tech companies have lived up to projections that seemed fanciful a decade ago.)
Talk of the town
At some point, the media cheerleading kicks in. The craze becomes part of a broader conversation and is no longer restricted to the business news.
It’s analogous to the Blue Jays’ run to the World Series last year. The further the Jays went, the more coverage they got outside of the sports section. People not usually interested in baseball were talking about it, wearing jerseys to work, and watching every game. This level and breadth of excitement is an important part of any investment bubble.
FOMO
With excitement comes regret and envy. Those who are not participating feel left out. They’ve watched as early believers made a ton of money. FOMO will prompt some of these outsiders to get on board, which helps keep the trend going in the later stages.
Trend-chasing products
The late adopters may be convinced to join in because of new investment products designed to take advantage of the trend. Asset managers can’t run the risk of falling behind, so a steady flow of new products come to market.
There are far more bubbles predicted than actually occur. You only know there’s one when the music stops suddenly and demand falls off a cliff, prices drop precipitously, jobs are lost, there’s headline stories about risk-taking gone bad, companies are forced to sell assets to reduce debt, and everyone tells you they saw it coming.
