What Causes Asset Bubbles?
As we showed yesterday, the price of bitcoin has finally surpassed “Tulips” in the global bubble race.
Overnight the former Bridgewater analysts Howard Wang and Robert Wu, who make up Convoy Investments, released their thoughts on what happens next… and most importantly, what causes asset bubbles…
When we see a dramatic rise in asset prices, there is often an internal struggle between the two types of investors within us.
The first is the value investor, “is this investment getting too expensive?”
The second is the momentum investor, “am I missing out on a trend?”
I believe the balance of these two approaches, both within ourselves and across a market, ultimately determines the propensity for bubble-like behavior. When there is a new or rapidly evolving market, our conviction in the value investor can weaken and the momentum investor can take over. Other markets that structurally lack a basis for valuation are even more susceptible to momentum swings because the main indicator of future value is the market’s perception of recent value. In this commentary, I quantify the balance of value vs. momentum in a market to explore how that tug of war can result in incredible asset bubbles.
The balance of value vs. momentum determines a market’s serial correlation
I believe the outcome of the tug of war between value and momentum in any market can be largely captured by a statistical measure called serial correlation – how likely is the recent past to determine the near future? A value of -1 means future returns are the exact opposite of recent past returns, a value of 0 means they are independent of each other, and a value of 1 means recent past returns are perfectly predictive future returns. After a dramatic price change, value investing would generally expect a reversion to the mean, suggesting a negative serial correlation.
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