Updated: Oct 7, 2022
Gravity Reasserts Itself at the Most Inconvenient of Times
One of our favorite sayings is a German proverb: Bäume wachsen nicht in den Himmel. It's often translated as "Trees don't grow to the sky", and was a favorite saying of former Federal Reserve Chair Paul Volker. Every financial mania has its apex. Sooner or later, the weight of the canopy overcomes the strength of the roots that anchor it to the earth and the tree comes crashing down.
Speculative assets--assets that depend upon market sentiment, rather than terminal value or cash flows for their value--are midway through the repricing process. Years of low interest rates drove easy liquidity and loose credit standards. In addition, the sudden availability of direct transfers from the government and reduced personal consumption provided ample funds for the inflation of speculative bubbles. The Nobel Prize-winning economist Robert Shiller defined a bubble in Irrational Exuberance this way:
A situation in which news of price increases spurs investor enthusiasm which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increase and bringing in a larger and larger class of investors, who, despite doubts about the real value of the investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.
Humans, we believe, are unique among the creatures of the animal kingdom in that we make meaning of our experiences, which is to say we tell ourselves and others stories about the world to make sense of what might otherwise appear random or absurd. It is intensely useful as a survival mechanism, in that it allows us to transfer knowledge without direct experience and to encode programs of behavior to act in unfamiliar circumstances.
Our narratives, however, can sting us when their basis in reality is poorly established, or their utility as rules for future action attenuates over time or with scale. It is not irrational to invest in a speculative asset while it is inflating; it is merely unreasonable to stay invested as it approaches or passes its apex. At this time, a valuation that seemed only to go up suddenly changes tack and only seems to go down--and the fall is much more vertiginous than the rise.
False narratives lose explanatory power, or they lead to wildly suboptimal outcomes, and then are quietly discarded. With time, even the fiercest of acolytes surrender, quiet in their resignation. We yet await the day when it is remarkable that the financial press runs a story not on cryptocurrencies' rise or fall, but on cryptocurrency at all.