Bubbles everywhere, how will all this end?

The Nyan Cat meme, featuring a flying cat with pop tart as its torso, leaving a rainbow in its trail, has become a trial-blazer of sorts. Its creator, Christopher Torres, sold the ownership of the GIF animation for $600,000 at an auction last month. The auction was held on a two-week-old platform and the sale took place in Ether, a cryptocurrency.

This is just one of the several such sales of digital collectibles, in the form of Non Fungible Tokens (NFTs), over the last couple of months. Even as market veterans and experts have been shouting themselves hoarse about the bubble in Bitcoin and other cryptocurrency prices and the palpable risk in SPACs (special purpose acquisition companies), they now have to contend with yet another fad — NFTs.

It’s clear that risk-on sentiment among investors is reaching a crescendo. This is manifest in these newer and more outlandish assets drawing investors’ and speculators’ fancy. The trouble is that there is no established measure to value assets such as NFTs or cryptos and they are racing higher simply because they are scarce and in demand. Buyers are reaching for these with the hope of selling at a higher price in the future.

This is a classic set-up for an asset price bubble.

How bubbles form

The formation of asset price bubbles has always been linked to the basic human trait — greed — that leads to suspension of rationality. It may be worthwhile recollecting the first of such reported manias — the Dutch tulip bubble in 1637. This was largely due to the golden age for the Netherlands making its citizens very rich. The search for an avenue to invest the wealth ended at a strange place — rare tulips infected with a virus that gave them very beautiful flame like patterns.

Besides being uncommon, these tulips took years to grow and the bulbs could not be moved or sold immediately, leading to trade in futures of these rare tulips. As speculation grew and more and more people believed that the futures could be sold at a higher level, prices spiralled. So much so that the cost of one tulip bulb equalled the cost of an upscale house in Holland. The bubble popped when the bulbs were not delivered at the specified auction and everyone realised that they were trading a worthless asset.

The same cycle played out in 2000, when investors stampeded towards dotcom stocks, taking the average PE multiple of stocks traded on Nasdaq close to 100. The pattern was the same in the sub-prime mortgage related assets in the US in 2007.

The new asset classes

No one will dispute the fact that there is a price bubble in cryptocurrencies. These assets have no intrinsic value and are trading higher only because their number is finite and everyone believes, as of now, that their price will continue hitting the roof. The fancy for crypto assets has now spilled on to NFTs. An NFT is a unit of data representing a unique digital item which can be collectibles, digital art, audio file, tweet, GIF, and so on. The owner pays a certain price to put his creation on the blockchain, where it is available to everyone to buy and sell with cryptocurrencies. But unlike cryptocurrencies, NFTs are unique and not fungible and the buyer gets the pleasure of owning a unique digital file.

While NFTs have been traded for around three years now, they shot in to the limelight with a flurry of sales at exorbitant rates in February and March this year. The most talked about sale was ‘Everyday – The First 5000 Days’, a collage of 5,000 crypto arts done over 13 years by Mike Winklemann, also known as Beeple. This was auctioned for $69 million. The other alternative asset in vogue — SPACs or Special Purpose Acquisition Companies — have an equally bizarre business model. Almost $83 billion was raised through SPACs in 2020, equalling the amount raised through regular IPOs last year.

The problem here is that investors have to blindly put money into shell companies that will then hunt for companies to acquire. With celebrities such as basket-ball star Shaquille O’Neal, tennis star Serena Williams and ex-Trump adviser Gary Cohn and a bevy of celebrity investors lending their names to these vehicles, investors have been falling over themselves to invest in these vehicles.

What’s going on?

It’s obvious that the root cause behind this hankering after high-risk assets is the enormous amount of liquidity being pumped in by the US Fed, the ECB, BoJ, et al . That coupled with near zero interest rates has made money easy to come by, for investing in the above.

The situation also brings to mind the last phase of a bull market described by Charles H Dow, co-founder and first editor of Wall Street Journal , in his epochal work, TheDow Theory , written around 1900. Dow had pointed out that the final, or third, phase of a bull market is marked by soaring prices of extremely high risk stocks with no intrinsic value, also called cats and dogs. The shoe-shine boys become active in this period and promoters make hay by launching a slew of IPOs.

It’s obvious that the bull market in equities that began in March 2020 lows has matured. With investors having already put money into the cats and dogs, the elevated risk appetite is now making them turn their attention to riskier asset classes such as SPACs, Bitcoins and NFTs.

The difference between equities and these assets is that equity prices are tied to an underlying business that has certain worth. But Bitcoin, NFTs, etc., are moving up only because of speculation. Also, equity valuation is not high enough to be called a bubble, yet. The Sensex’s current trailing PE, while close to the level recorded in 2000 and 2008, has still not reached the mark reached during the Harshad Mehta boom in 1992.

How will all this end? It’s all up to central bankers. As soon as they begin hiking interest rates (this could be due to the threat of inflation spiking) there is likely to be a sell-off in all risky assets. With no fundamental mooring, crypto assets, SPACs, etc., face higher risk compared to traditional assets such as stocks or gold.

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