The anatomy of bubbles

Dear Gala,

At some point someone your age will show you a chart. The line goes up and to the right, steeply, and the person showing it to you will have a story about why. The story will be new. It will involve a technology you half understand and a future in which the old rules do not apply. Everyone around you will own some. This letter is about what to do with that chart.

In the first letter I told you about Charles Kindleberger and the five stages that every crash has gone through for four hundred years. This letter goes back to the beginning of those stages, to the part where the price is still rising and everybody is happy, because that is the part where the decisions get made.

A flower in Haarlem

In the Dutch Republic in the 1630s the fashion was tulips. The rarest ones had striped petals, and a single bulb of the best varieties could sell for the price of a house. Then, in the winter of 1636 to 1637, the prices of ordinary bulbs, the kind sold by the pound, rose as much as twentyfold in a few weeks. Contracts changed hands several times a day for bulbs that were still in the ground. On a day in early February 1637 an auction in Haarlem found no buyers. Within days the market was gone.

That is the legend, and for three hundred years it was told as pure madness. In 1989 Peter Garber went back to the records and found something more useful. Most of the tulip trade had been ordinary. Rare bulbs are expensive when they are new and fall in price as they multiply, and that is what happened to hyacinths a century later. What Garber could not explain was the last month, when common bulbs went up twentyfold and came back down. That month is the bubble, and it is the part I want you to keep. The bulbs were the same bulbs in January as in December. The only thing that had moved was the price, and people were buying because it was moving.

The same story every time

Kindleberger wrote his book in 1978, and the thing that struck me when I read it is that the bubbles were never built on nothing. Every one of them started with something real. Canals, railways, electricity, radio, the internet. The technology was as good as the enthusiasts said, and usually better. The railways did change the world. Most of the people who bought railway shares in the 1840s still lost their money, because the price of the shares had stopped having anything to do with what a railway could earn.

That is the trap I want you to see. The question of whether the technology is real and the question of whether the price makes sense are two different questions, and a bubble is what happens when people answer the second one by pointing at the first. Add cheap credit, so that people can buy more than they have, and the rise feeds itself. Kindleberger found that credit was the fuel in every episode he studied. Without borrowed money, a mania is a fad. With it, a mania becomes a crisis.

The story that sells itself

Robert Shiller published a book called Irrational Exuberance in March 2000, the same month the Nasdaq index of technology stocks reached its peak. Over the next two and a half years the index lost about three quarters of its value. Shiller has said the timing was luck, and I believe him, but the argument in the book was right.

His mechanism is a loop. The price rises. People look for a reason, and a story appears that explains the rise. The story brings in new buyers, the new buyers push the price higher, and the higher price seems to prove the story. Shiller went through a century of these stories and found that each generation had its own version of the same one: a new era has begun and the old measures of value no longer apply. In 1901 it was the great industrial combinations. In the 1920s, electricity and the car. In the 1960s, television and space. In the 1990s, the internet. Each time, prices fell back to what profits and dividends could justify. The new era was real. The idea that it had changed how to value a company was wrong. As I write this, the story of our era is artificial intelligence. It may be the one that finally is different. Time will tell. Until then I keep valuing companies the way I always have.

The test Shiller gives you is simple. Ask whether the story explains the price, or whether the price produced the story. When you notice that the explanation arrived after the rise and keeps changing as the rise continues, you are inside the loop.

What the numbers say

In 2019 Robin Greenwood, Andrei Shleifer and Yang You went through every industry in the American stock market since 1926 and found the forty times an industry’s shares had doubled in two years. Then they looked at what happened next. After a doubling, the odds of a crash, a fall of forty percent within two years, were fifty-three percent. After a rise of one hundred and fifty percent, eighty. And the crashes had a look to them: volatility jumped, new companies outran old ones, share issues multiplied, and the price accelerated.

So the signs are real and can be measured. And still, almost half of the forty did not crash, and an investor who sold every one of them did worse than one who did nothing. The pattern tells you the ground is fragile. Nobody can tell you when it will give way, or whether it will.

Now the chart

Now the chart. By the time you read this, bitcoin may be part of how the world pays for things, or it may be a word your friends have never heard. I do not know which, and it does not matter for what follows, because the chart looked the same either way. In March 2020, at the start of the pandemic, a bitcoin cost about five thousand dollars. In November 2021 it touched sixty-nine thousand. A year later it was under sixteen thousand, a fall of more than three quarters, and along the way several of the companies that had lent against it or held it for their customers had failed. Then, in March 2024, the price passed its old high.

I want you to notice that every item on Greenwood’s list was there. A real technology underneath. A story about a new era in which the old measures did not apply. New buyers who had never owned anything before. Borrowed money, a lot of it. A price that accelerated. Volatility that exploded. And then, after the crash, the thing came back, which is exactly what the paper says can happen. The signs tell you how the ground is built. They do not tell you where it will be in three years, and anyone who tells you they know is telling you a story.

What I do

I ask the question that does not depend on the price. What does this produce. A farm produces grain. A building produces rent. A company produces profits, and even a company with no profits yet can show you what it would sell and to whom. Gold produces nothing, and I have written to you about why I keep a little anyway. I do not hold any bitcoin. I have read too much about bubbles to believe in it, and everything in this letter is why. I may be wrong. For years now the price has been telling me I am wrong, and most of the people I know own some, so I am moving in the opposite direction from the crowd, and I know how that looks. At dinner tables, when the conversation turns to it and everyone has a number, I stay quiet, or I say that I do not own any and leave it there. Whether I turn out to be right is a separate question, and the market will answer it without asking me. What I can control is the other thing. I studied it, I asked what it produces, and I did not like the answer. Buying anyway, because everyone at the table was sure, would have meant going against my own judgment to keep up with the crowd. I would rather be wrong on my own account than right on someone else’s.

With love,
Papá