Basic economics tells us that prices are set in the market by matching supply to demand. From this it's easy to conclude that prices must reflect value. However, prices can be manipulated so as to misrepresent the true value of things. The naïve investor can be duped into buying something for much more money than it's worth. He can also be duped into selling things way cheaper than true value.
The way this is usually done is by introducing a certain level of churn in the investment target, and to systematically lift or suppress the price in the process.
As an example, we can imagine four guys coming together with the goal of lifting the price of some illiquid stock that they all own. Instead of waiting for outsiders to bid up the stock, they agree among themselves to trade their stocks in a circle. The first guy sells a given number of shares to the next guy, who sells these on to the other two, who in turn sell them back to the first guy. This is then repeated, every time in a slightly different manner so as to escape detection.
The result of this is that the price of the stock is set by the circle of friends rather than the market. If done convincingly, it looks like normal market action. Outsiders who monitor the market may not be able to distinguish the manipulation from normal price discovery. They see a sudden flurry of activity and conclude that something big is about to happen. They jump in to get a piece of the action. That's when the group of friends sell their stocks, leaving the outsiders to hold the bag.
Key to success in this is that the churn is big relative to the underlying asset. The more churn there is relative to actual retail demand, the more freely the price can be manipulated. We must therefore view with suspicion any market where there's a lot more churn than retail demand would suggest.
Looking at the turnover in the gold market as well as in Bitcoin, we get numbers that dwarf what we would expect based on retail demand. The London gold market transacts gold contracts every day equal to annual global gold production. Bitcoin exchanges have daily turnovers in the billions of dollars. Very little of this is driven by retail demand. Almost all of it is churn. Prices for gold and Bitcoin are largely set by big actors seeking to manage the markets to their advantage. However, there's a limit to how long such manipulations can continue before reality sets in.
Gold prices are known to be manipulated lower by bullion banks operating on behalf of central banks in order to make fiat currencies look stronger than they are. The churn is used as a way to keep gold prices down. However, this introduces opportunities for prudent investors with long time horizons. Gold is always cheap relative to what it would be if not manipulated. It's therefore a pretty safe long term investment. Its price will either follow a relatively uneventful trajectory upwards in line with what manipulators are able to engineer, or it will at some point explode higher when the bullion banks at some point run out of gold.
Conversely, Bitcoin prices are likely manipulated up by Bitcoin whales who introduce churn by trading among themselves, setting the price higher as they go. However, Bitcoin generates no cash flow. Holding onto Bitcoin is only possible at the expense of cash savings or going into debt. Making this all the more difficult is the fact that Bitcoin is constantly leaking dollars through fixed costs. Sooner or later, Bitcoin manipulators will run out of dollars. The only thing preventing this from happening in the short run is a steady stream of naïve investors, bringing fresh cash into the Bitcoin community.
Similarly, we can see that stock markets the world over are in a bubble. Stock prices are so elevated that investors find themselves in a situation similar to that of Bitcoin owners. Some stocks even have the same negative cash flow that we've identified in Bitcoin. That means that they must be sold at some point if the owners are to avoid eroding savings or going further into debt. Other stocks may have positive cash flow, but so little of it that investors nevertheless have to sell at some point. Very few stocks are priced at levels that allow the average owner to live off of their cash flow for retirement.
The stock market bubble is also a function of churn. However, this has come about, not so much from coordinated manipulation of stock prices themselves as from central bank manipulation of money supply and interest rates. Artificially low interest rates have made everything more expensive than it would otherwise have been, thereby making it close to impossible to save for retirement.
This problem is not confined to retail stock investors. It exists for pension funds as well. They too must sell in order to cover future commitments. The stock market bubble must therefore pop at some point, if not in nominal terms, then in terms of purchasing power. There simply isn't enough value in the stock market to support current prices over time. The future will see selling pressure, with few people able or willing to buy before prices better reflect earnings.
This is in the end the big difference between prices and value in markets. It is easy to mistake one for the other, especially when markets have been mispriced for a long time. But the fact remains that price is what we pay and value is what we get. The two are not the same.
Confusing price for value can be a costly mistake, as well as an embarrassing one, because true value always reveals itself in the end, clear for all to see. Not only does the bag holder loose his investment, he's also everybody's laughing stock. But just because something is unsustainable over time doesn't mean that it can't go on for a very long time. We mustn't confuse the inevitable with the imminent. That too can be a costly mistake. Many have gone bust trying to short a bubble or catch a falling knife. The fact that they are proven right in the end when the bubble finally pops, or the knife ricochets to new highs, is of little comfort to those who ended up broke on the way.
This is why we should make long term investments rather than short term bets. In the long run, prices return to fair value. They even have a tendency to overshoot, giving long term investors plenty of time to roll their portfolio over from one asset class to another.
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By Kropsoq - photo taken by Kropsoq, CC BY-SA 3.0, Link
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