January 12, 2022 phillip_toews_1p9l0e9h

The past year was the year that investors proved that irrationality is unbounded:

  • Retail investors bid up GameStop, a company that was arguably headed for bankruptcy, to a valuation of over $22 billion, making it the largest company in the Russell 2000 Indexi.
  • Cryptocurrencies (Bitcoin, Etherium, etc.), reached a collective total valuation that exceeded $3 trillion, or 14% of US GDP.
  • Some guy or gal paid $600,000 for this Poptart/Cat meme.

To put the above into perspective, it helps to understand that at the time that GameStop rallied over 100X, from a price of around $4 to $483, it had an operating loss of $287 million dollars, with no real prospects for increased revenue or earnings. That’s important to understand. There are times when companies have losses and what appears to be an unrealistic valuation, but then later become hugely successful enterprises. An example of this is Amazon, which for years produced losses while investors valued it at billions of dollars. Amazon, however, had a viable business model and was a major disrupter in retail sales. Investors were betting that, given enough time, Amazon would justify the high stock price by ultimately becoming successful.

The critical difference between GameStop and Amazon is that the GameStop rally was the equivalent of a retail investor Ponzi scheme. Investors that were in early, and got out before it crashed, made a fortune. New investors, however, were just transferring their money to the early investors because, once it crashed, there would be no new investors to buy and support the rocket high price. In other words, investors only bought because the price was rising, and they thought that they could sell before the price peaked. There was no real expectation that GameStop would meaningfully grow.

That brings us to crypto currencies like bitcoin. As you see above, by comparing the price to its earnings, it was easy to see that the price of GameStop was bonkers. Bitcoin, however, has no earnings, and no assets. As such, it is a speculative frenzy that is untethered to any realistic valuation measures. Actually, let me modify that: Its fundamental value is zero dollars. So how can it be that something with a fundamental value of zero dollars can be priced as high as $69,000 per Bitcoin?? The phenomenon that drives the price of Bitcoin is identical to GameStop. The price has gone higher over an extended time. Investors that came in early have made a fortune, and others believe that they can invest and make their own fortunes because the price rise may continue, before it crashes. Because Bitcoin has rallied for so long (it was created in 2009), it produces the illusion that there is something valid supporting price increases.

Helping create the illusion of value is the name “currency,” which implies that it is stable and reliable and in some way supported by some entity like a government. Of course, it isn’t. And currencies aren’t a way to make a fortune. One dollar in 2009 is worth….one dollar today. In real, after inflation terms, it’s worth less today.

But here’s where it becomes fascinating. The historic rise of this worthless non-asset has been so tempting that over the past twelve months, the largest asset managers in the world have begun investing too. In August it was revealed in SEC filings that Blackrock, the largest US asset manager, with some $9 trillion in assets under management, had approximately $400 billion invested in Bitcoin mining firms. They’re not alone. The first Bitcoin ETF was launched last year, and many other companies have filed to do the same. Other major asset management firms are figuring out ways for their investors to have access to Bitcoin. When big institutional investors take stakes in speculative assets like Bitcoin, it adds sense of validity for smaller investors. The participation of institutional investors in the markets for Bitcoin creates more demand, and the possibility that cryptocurrencies may rally even further. They touched 14% of US GDP in 2021. Could it reach 50%, 100%, or 300% of US GDP?

One day (soon I believe), we will all look back on these events as indicative of one of the greatest and most captivating bubbles in market history. Over the course of the past year, we began referring to the phenomenon as “digital tulip bulbs,” alluding to 17th century tulip mania that saw single tulip bulbs selling for tens of thousands of dollars.

Speculative Assets can Bring Down the Building

So how does all of this affect you, the rational investor/advisor that is allocated to stock market indices and bond funds that are based on real earnings and assets? Fortunately, we don’t have to look back far to find answer to that question. During the internet bubble, some stocks were more reasonably priced than internet companies. Yet, when the internet bubble crashed, the S&P lost half of it’s value over 2.5 years, causing the economy to fall into a recession.

Similarly in the early aughts, housing prices were in a bubble. Even though stocks were priced reasonably, the housing crash weakened the financial system, caused stocks to lose over 50%, and again caused a recession.
The financial ecosystem is like a building. Each asset is part of the structure. If weak components (speculative assets) become a large enough part of the building, the integrity of the whole structure may be compromised.

The super easy money policy of the Federal Reserve has created a situation where the bubble has spread from speculative assets into broad market indices, creating additional risks of a stock market decline.


The challenge for investors during elevated or risky markets is to both attempt to participate in rallies, as they may last a very long time, but also address the possibility of a falling market or even a market crash.
With valuations and inflation high, act before declines mount to attempt to address the contingency of falling markets, take the following steps:

  1. Invest in hedged equity or high conviction tactical portfolios in an attempt to address stock decreases during times of over-valuation.
  2. Move fixed income portfolios into adaptive or unconstrained funds that attempt to mitigate the effect of rising rates or inflation.

For investors that take these steps, don’t stress about elevated markets. If they do fall, you may be able to benefit by minimizing declines, but participating in the subsequent rally.


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