Playing the Financial Bubble Game, by Arnold Kling

An article published in Hacker Noon, Playing the Financial Bubble Game, by Dr. Kling, went viral.

And yet it is mathematically impossible for all of the bullish investors to get out with a profit. If a stock goes from $10 a share to $100 a share and back down to $5 a share, then on average the shares bought on the way up have to be sold for less than their purchase price on the way down. If you buy into a bubble, then the chances are you will lose.

No kidding, if the ending point is lower than the starting point, all else being equal. But an obvious example where it is possible is if the company is acquired for $100/share, hence everyone comes out ahead.

Bubbles are only knowable in retrospect, not in real time. Amazon sure felt like a bubble when it surged from $100 to $200 a share many years ago, but in retrospect given how Amazon dominates retail and cloud hosting and how much earnings have grown, such rapid share price appreciation was justified even though at the time it felt like a bubble.

The winners are those who sell close to the top, as we did with out Internet company. The losers are the many who buy on the way up and are unwilling or unable to get out before the crash takes place.

You don’t say…

Which brings me to Bitcoin. There are many people who will tell you that they have made money by being bullish on Bitcoin. But that is delusional. In order for people to realize their Bitcoin profits, they would have to sell, and if a lot of people sold, then that would have driven the price of Bitcoin down.

Instead, it is a mathematical near-certainty that most people who believe that they have made large profits on Bitcoin are still holding most of their Bitcoin, so that their profits only exist on paper. And if Bitcoin crashes, which I expect it will, most of those people will not be willing or able to sell before their large paper profits have turned into small paper losses.

This is true, and the problem is amplified by the fact there are many Bitcoin exchanges, which reduces the effective liquidity as discussed here.

Consider a hypothetical currency, Crap Coin (CC), which issues 15 million coins. If the creators of CC pre-mine 1 million coins, then list CC on a coin exchange, and CC gets bid up to $10, the founders of CC are worth $10 million on paper. But there would likely be very little liquidity, such that if the founders tried tried to sell anywhere close to their million coins the price would fall a lot. Maybe they could sell a couple hundred at most without affecting the price too much. This in and of itself is not a problem. It can become problematic, however, if the illusion of liquidity is used as collateral, for example, if the founders of CC use their $10 million of unrealized profits as collateral for a loan and or if they sell their holdings to an institution such as an investment bank. But if someone sold a lot of CC at once, such as 10,000 coins, the price of CC would fall a lot and the bank would suffer a significant unrealized paper loss, but such a loss would still have to be reported in the bank’s quarterly reports, and this would cause the share price of the bank to fall and investors to lose money. This is similar to the house market crash in 2006, in which homeowners borrowed against the equity in their home, and the banks ate the losses when home prices fell and the stability of the housing market was revealed to be no more than an illusion.

Does that mean that going short Bitcoin is a sure bet? No. There is a saying, often attributed to John Maynard Keynes, that “the market can stay irrational longer than you can stay solvent.” This makes it perilous to try to fight a mania. If you saw the movie The Big Short, or read the book, you know that if the market for mortgage securities had stayed irrational a few months longer, at least some of the bearish speculators would have been wiped out before their positions were vindicated.

This is good advice, and for every person who bet against a rising market and makes money, many fail but get much less media coverage. No one is going to make a movie about the people who bet against the housing market and lost.

But if I am correct that Bitcoin is a bubble, then somebody at some point can make a fortune by selling Bitcoin short, perhaps on the futures market that recently opened. The other big fortunes in Bitcoin will be made by the few who sell their Bitcoin while the the bulls still outnumber the bears. And once again, it is a mathematical near-certainty that most of the bulls will not get out in time.

As mentioned above, very few people make money betting against rising markets. Look at all those chumps who lost money over the past nine years betting against the biggest and longest bull market ever (S&P 500 up 300% since 2009 lows). Or those who sold in 2016 because they thought Brexit and or Trump would be bad for the stock market and economy. Yes, someone (as in maybe a handful of people) will make money, on top a mountain of losers.

My advice is to stay away from playing the bubble game in financial markets. Let other people buy Bitcoin. Let other people short Bitcoin. Let other people buy stock market darlings like Amazon at extraordinary multiples of their recent earnings. Instead, invest in assets where the price has a more reasonable relationship to reality.

This blog was right about Amazon, in 2014-2016 having predicted it would go much higher. Risk taking, if done correctly such as through the methods outlined in this blog (such as the HBD investing method, NRx tech-com, altcoin speculation method, etc.), can work. Without some uncertainty, there is no market. Price discovery is the collective process of market participants through casting votes via buys and sells, determining what something is worth.