How the Crypto and Meme Bubbles Threaten Ordinary Investors

Cornell’s point is that asset bubbles don’t last forever.

They disappear when, for example, the Reddit meme that drove the value narrative fades away. Eventually assets settle and the last investor who bought into the narrative © is forced to accept the reality that A and B now have two units of his/her wealth. Why? They either created the narrative or got out early.

For a while, however, on the aggregate everyone felt wealthier. Some held their wealth in real assets and others in bubble assets.

Bubble wealth is driven by a catalyst that forms the narrative of value. In the tech bubble it was the “new economy.” In the housing bubble, it was the story that houses always increase in value. Today’s memes that promise instant wealth while “sticking it to the man,” or an alternative asset free of the constraints of fiat currency, offer a new and exciting narrative for investors seeking the thrill of bubble wealth.

None of us knows exactly how or when today’s bubble wealth will shake out into real asset winners and losers. GameStop had a market capitalization of less than $300 million one year ago. At the time of this writing, its market cap was $12 billion. Investors on the aggregate hold $11.7 billion more wealth today than they did a year ago in shares of a company that has thus far lost $170 million in 2021. Are investors $11.7 billion richer today?

Fortunately, you and I are disciplined, long-term investors who value real, productive assets. We can’t fall into the bubble-investor trap when wealth eventually evaporates. I am a (long-suffering) value investor who holds low-cost passive funds.

Unfortunately, I’m also a GameStop investor. Investors who held value or momentum ETFs benefitted from the rise in meme stocks this year (GameStop rose to more than 5% of assets for some momentum ETFs). The Russell 2000 sold off its GameStop in June because the company became so large (investors became person B in the example above who sold off their coin before the bubble burst). In fact, much of the rally in value ETFs in 2021 came from meme stocks like AMC and GME.

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.

Elasticity – the power that drives bubbles

Efficient-market types believe that prices of stocks (or coins) always reflect fundamental values. In 1981, Robert Shiller pointed out that stock prices are too volatile to reflect rational expectations about variation in future earnings, resulting in a torrent of subsequent research on the impact of investor sentiment on asset prices. Investors’ enthusiasm for stocks ebbs and flows and is often driven by “shiny” stocks that grab the attention of short-term speculators. These speculative investors crowd in and out of high-sentiment stocks at the same time, driving prices up when sentiment is high and down when it is low.

New research by Harvard Professor Xavier Gabaix and Ralph Koi of the University of Chicago estimates the price impact a small number of investors can have on the price of stocks. Their results show that stock markets are surprisingly inelastic, which means that a small increase in demand can result in a big increase in prices. Of course, stock demand can also fall. Like gas prices in a market where demand dropped suddenly during a pandemic, price inelasticity also means that a modest decrease in demand can result in a sharp decrease in stock prices.

Gabaix and Koi estimated that $1 invested in stocks results in a $5 increase in total market capitalization. This means that institutions such as the Federal Reserve can use a relatively modest amount of capital to buffer market volatility, that stock repurchases can drive prices (and the value of executive stock options) up more than expected, and that a bunch of investors on Reddit can inflate the price of stocks with a modest amount of coordinated buying pressure.

An advisor can avoid the eventual loss of bubble wealth from inflated stock prices by avoiding speculative stocks, but the inelasticity of the overall market should serve as a warning to stock investors who believe that market prices always reflect fundamental values.

In 2011, David Nanigian of San Diego State, Eric Belasco of Montana State and I published an article that found a significant valuation impact from excess flows into the S&P 500 (relative to stocks outside the index). When investors poured more money into the index, the valuation of stocks in the index rose more than stocks outside the index with similar earnings. Our research helps explain why stocks added to the S&P experience a price bump that has risen with the popularity of index investing. It also means that popular indexes contain a certain amount of bubble wealth.

The flows into funds that hold popular indexes like the S&P 500 are staggering. Two of the five ETFs that received the highest net flows over the last year were S&P 500 funds (Vanguard and iShares) and two others were heavily invested in S&P companies. Every month workers pour billions into popular indexes, adding positive demand pressure into inelastic stocks that have now pushed valuations of the S&P higher than at any point in U.S. history other than the tail end of the late 90s tech bubble.

Getting real about bubble wealth

Can a worker retire on $2 million of investment assets? Imagine that workers A, B and C in the original example each have the same amount of wealth, but C has a larger percentage of bubble wealth whose market valuation has been temporarily distorted. C’s wealth foundation will be shakier than the nest egg of assets held by A and B.

A risk posed by the inflated market for financial assets is that too many workers base the decision on a retirement goal. Once they reach the goal, workers feel like they have enough. A challenge of using a goal-based investment process with fixed dollar value thresholds is that meeting the goal provides less financial security when that goal is based on bubble wealth.

The problem, however, isn’t limited to workers retiring early on their cypto and meme stock wealth. Even investors holding well diversified portfolios of so-called “real” assets will need to change their goal in a frothy market filled with bubble assets that index investors can’t avoid.

Michael Finke, PhD, CFP®, is a professor of wealth management, WMCP® program director, and the Frank M. Engle Distinguished Chair in Economic Security Research at The American College of Financial Services.

Read more articles by Michael Finke