…it was very difficult to definitively identify a bubble until after the fact: that is, when its bursting confirmed its existence… (Alan Greenspan, 2002)
Saxo Bank has recently published its outlook “HOW TO SPOT A BUBBLE”, which describes the methodology of identifying bubbles in the financial markets.
In my opinion, the approach is really interesting because it is simple and logical. And in order to practice it, let’s apply it to Amazon (NASDAQ:AMZN) and PayPal (NASDAQ:PYPL).
Let me explain briefly the essence of the method on the example of Bitcoin because hardly anyone now doubts that it was a classic bubble.
Setting aside the theoretical reflections on the nature of the processes in the world, according to Saxo Bank “… a bubble may be characterized by super-exponential behavior where the growth rate continually increases…”.
Let me show you what it means, putting it into practice.
Here are Bitcoin prices on the log-plot. The logarithmic y-scale is a prerequisite for this methodology.
And now pay attention to this: since the beginning of 2013 to mid-2014, Bitcoin price was growing along the exponential trend that always looks like a straight line on a log graph yellow curve). From 2015 to January 2018, Bitcoin price grew at the super-exponential rate that looks like an exponential curve on the log graph (red curve). This period falls under the definition of “bubble formation”.
The ending period of bubble formation is also visible on the chart of annual growth rates of Bitcoin price:
I’d like to note that this approach does not allow to define the moment when the bubble will burst, but allows to understand that we are dealing with the bubble.
Now let’s look at daily prices of Amazon on a regular graph:
It really looks like a bubble.
Let’s now look at these same prices on the log graph, adding an exponential growth trend to it:
We see quite a steady growth along the exponential trend (once again – it always has the form of a straight line on the log graph).
Now, look at the annual rates of change of Amazon share price. Starting from 2010, nothing even remotely resembles Bitcoin growth rate of the year 2017.
So, from the point of view of this methodology, there is no reason to argue that the bubble is forming here. Amazon grows harmoniously within the framework of its long-term growth rate.
Now let’s look at PayPal shares on the log graph, adding the trend line:
Here the situation is different, and the trend line is not straight.
Now let’s look at the YOY growth of the day prices of PayPal shares:
Something extraordinary was witnessed here over the last month because the 100% YOY growth of day prices is huge even for Amazon.
Since we are already talking about PayPal, I suggest to take a look at the graph of one-year rolling Beta coefficient:
As you can see, the Beta of PayPal has been demonstrating a steady tendency for growth since the beginning of 2017 and is now above the upper border of the standard deviation. The growth of Beta usually indicates an increased speculative interest in shares – it normally occurs and when a bubble is forming.
Of course, PayPal is still a relatively young company that has a great potential. And I’m not trying to say that PayPal is a bubble just like Bitcoin. No! But bubbles can have different sizes and formation periods. And speaking of PayPal, I believe that we are dealing with a local, so to speak, small bubble, because since 2017 the growth rate of PayPal moved from the exponential category to the super-exponential one, and the methodology proposed by Saxo Bank identifies it very clearly. Moreover, the 100% YOY growth rate of day prices demonstrated by PayPal shares will not last forever.
Relatively recently I created the DCF model for PayPal which also identified the overvalued state of PayPal shares.
Putting It All Together
Saxo Bank has offered an interesting tool, and I personally, will adopt it.
Amazon is not a bubble. However, the growth of PayPal has deviated from the exponential trend in the short term, and this can be regarded as the local bubble that will snuff out sooner or later, lowering the stock price to the level of the normal growth trend, which in my estimation is now around $60.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.