A recent paper by UCLA emeritus professor Bradford Cornell takes aim at the ethereal richness of cryptocurrencies and proposes an essential thought experiment on the worth of financial assets. Cornell wants readers to assess whether the current market value of cryptocurrency equals $1 trillion in wealth. If crypto can be traded and converted into $1 trillion in fiat currency, there should be no doubt about its worth.
A bubble arises when the price of an asset rises far above its intrinsic value. Bubbles frequently occur when investors’ imaginations are stoked by unreasonable expectations, strong recent price gains (and the fear of missing out), and, most importantly, a fundamental value that is opaque and subject to wide difference of opinion.
The article provides an example of a three-person economy (A, B, and C). Each has ten units of “actual” wealth. A creates a digital coin, creates a value store for it, and sells it to B for one unit of wealth. Now since A has 11 units and B has 9 plus the coin, which is worth one unit, the three of them have a total of 31 units of wealth.
C wants in on the action and purchases the currency from B for two units of wealth. A and B now both have 11 units of wealth, while C has 8 units plus a coin worth two units of money, for a total social wealth of 32 units. The three are now two units wealthier as a group. C, on the other hand, is stuck with a coin whose value storey was created by A and approved by A and B. If no one accepts the value tale any more, A and B still have 11 units of wealth, whereas C (the poor sap) has 8 units of wealth and a worthless coin.
Cornell’s point is that asset bubbles do not last indefinitely.
Bubble wealth is propelled by a trigger that shapes the value storey. It was the “new economy” during the tech bubble. During the housing bubble, the storey was that houses always increased in value. Today’s memes that promise instant fortune while “sticking it to the guy,” or an alternative asset free of fiat currency limits, provide a new and exciting narrative for investors seeking the thrill of bubble wealth.
Nobody knows when or how today’s bubble riches will be sorted into real asset winners and losers. One year ago, GameStop had a market capitalization of less than $300 million. Its market capitalization was $12 billion at the time of writing. In aggregate, investors have $11.7 billion more wealth today than they did a year ago in shares of a company that has already lost $170 million in 2021. Are investors now $11.7 billion richer?
Fortunately, you and I are long-term, disciplined investors who appreciate actual, productive assets. When money inevitably vanishes, we cannot fall into the bubble-investor trap. I am a (patient) value investor who invests in low-cost passive funds.
Strategies such as low-volatility and high-profitability funds are designed to avoid bubble wealth. Research shows that by avoiding high-sentiment stocks favored by investors who buy into a narrative of value, rather than evidence of real value, results in consistent outperformance over time. One reason for bubble formation is a divergence of opinion among investors about stocks with no history of profitability. For these companies, the price of the company is determined by the imagination and optimism of bubble investors. Companies that are already profitable are far more boring.