Is Cryptocurrency a Bubble?

“Those who fail to learn from history are condemned to repeat it.”

-Winston Churchill

You may have heard of cryptocurrencies such as Bitcoin. You may have even purchased some hoping that the price would rise and you could cash out. If you made money, that’s great. There is nothing wrong with buying something and hoping the price is going to rise if there are fundamental reasons why it should with evidence to back it. That being said, however, I consider buying cryptocurrencies as pure speculation and I’m going to argue they share the same characteristics as bubbles in the past.

Every speculative bubble is driven by euphoric optimism about what the future price might be. Once the price starts rising, people investing are making money, and gain confidence in their investing abilities. They may start investing more, and being caught up in the frenzy, become less selective in their investing criteria. Prices thus continue to rise, and others, seeing people make money, jump into the fray. The prices eventually exceed the undervaluation of the asset, and one-day prices start to fall as people cash out their gains. Once the price falls, people may find there are no buyers and have to sell at lower and lower prices to try and get out. Panic then ensues and everyone rushes out the door, resulting in a crash.Time and time again this cycle has repeated itself. Does this remind you of anyone you know?

Charles P. Kindleberger, in his book, Manias, Panics, and Crashes: A History of Financial Crises, lists the top 10 financial bubbles:

1) The Dutch Tulip Bulb Bubble 1636

2) The South Sea Bubble 1720

3) The Mississippi Bubble 1720

4) The late 1920s stock price bubble 1927-1929

5) The surge in bank loans to Mexico and other developing countries in the 1970s

6) The bubble in real estate and stocks in Japan 1985-1989

7) The 1985-1989 bubble in real estate and stocks in Finland, Norway, and Sweden

8) The bubble in real estate and stocks in Thailand, Malaysia, Indonesia, and several other Asian countries 1992-1997

9) The surge in foreign investment in Mexico 1990-1993

10) The Dot Com Bubble 1995-2000

I would also place the housing bubble of 2008-2009 and, more recently, cryptocurrencies on that list. Let’s explore a few of the most famous bubbles, what led to them, and how cryptocurrencies share the same characteristics.

The Tulip Mania

Often quoted as one of the first speculative bubbles, Tulip Mania was a period in the 1630s in the Netherlands, when speculators traded the flower’s bulbs for extraordinary sums of money, due to their luxury status, until, without warning, the market collapsed. Ever since the cautionary tale of Tulip Mania has been studied as the first example of a bubble.

As the flowers grew in popularity professional growers paid higher and higher prices for the bulbs, some upward to several hundred percent, and prices kept rising. By 1634, speculators started entering the market. The contract price for rare bulbs continued to rise throughout 1636, but by November, the price of common bulbs began to increase, so that any tulip bulb could fetch hundreds of guilders (the currency at the time). The peak hit in the winter of 1636 when earlier that year the Dutch created a type of formal futures market where contracts to buy bulbs at the end of the season were bought and sold. The Dutch described tulip contracts as windhandel (meaning “wind trade”) because no bulbs were actually changing hands; people were buying without seeing the bulbs in person. They believed that seeing the bulbs did not matter when they could sell it at a higher price to someone else later.

At one point some bulbs were reportedly changing hands ten times in a day. Some of the transactions were worth 10,000 guilders (the currency at the time). To put this in perspective, 10,000 guilders was enough to feed, clothe, and house a whole Dutch family for half a lifetime, or sufficient to purchase one of the largest homes in Amsterdam for cash. 

No deliveries were ever made to fulfill the contracts because by February 1637, tulip bulb contract prices collapsed and the trade of tulips grounded to a halt. This happened because most speculators could no longer afford to purchase the cheapest bulbs. Demand disappeared, and flower prices dropped to a tenth of their former values. The result was financial ruin for many. Disputes over debts went on for years after.

The South Sea Bubble

Even the smartest people are not immune to the allure of easy riches. An early example is Isaac Newton and his investment in the South Sea Company. The South Sea Company was established in the early 18th Century and was granted a monopoly on trade in exchange for assuming England’s war debt. Investors were attracted to the appeal of this monopoly and thus the company’s shares rose. Isaac Newton was one of these investors, investing some money and profiting off his initial investment, selling his shares at a 100% profit of £7,000 on April 20th. Later an infection from the mania gripping the world that spring and summer caught up to him and he bought a larger number of shares near the market top, over three times the price of his original stake, and then proceeded to lose £20,000, equal to $3 million (in 2002-2003 money); almost his entire life savings. He later stated, “I can calculate the motions of the heavenly bodies, but not the madness of people.” Afterward, he put it out of his mind and never for the rest of his life could he bear to hear the name South Sea.

The Dot-com Bubble

The dot-com bubble (also referred to as the tech bubble or internet bubble) refers to the speculative investment bubble that formed around internet-based companies between 1995 and 2000 and then the sudden plunge in late 2000 to 2002. During the crash, many online companies failed, such as Pets.com, while others saw their stocks plunge with companies like Cisco dropping by 86%.

During the mid-90s, internet adoption exploded, with more and more people going online as computer ownership progressed from a luxury to a necessity. During this time, hundreds of new companies formed, taking advantage of low-interest rates, and the public flocked to invest in them, themselves taking advantage of a lower capital gains tax that had recently been passed in the United States and the belief that online commerce was the future. This speculation led to people willing to invest at any valuation, in any dot-com company. Venture capital firms jumped on board with capital easy to raise, and investment banks were profiting from initial public offerings, fueling the speculation and investment in technology companies.

Between 1995 and 2000, the NASDAQ, rose by ~400%, from about 1,000 to a high of 5,132. Companies were going to market with IPOs and fetching huge prices, with stocks sometimes doubling on the first day. In March 2000, everything changed. On March 10, the combined values of stocks on the NASDAQ peaked at $6.71 trillion. On March 11ththe bubble popped. Over the next few years it continued to drop hitting a low of 1,114 on October 9, 2002; a drop of 78%. Stocks lost $5 trillion in market capitalization. Amazon, once one of the tech darlings of its day, fell from $107 to $7. It took over 15 years for the NASDAQ to recover to its previous high.

The Signs of a Bubble

Bubbles are often only identified in retrospect after the bubble has burst. Even if a bubble is identified, it could be years after before anything happens with the market continuing its march upward. Former Federal Reserve Board chairman, Alan Greenspan, gave a speech December 1996, saying that the market had reached “irrational exuberance” meaning that the market might be overvalued. It continued to rise for another 3 years. That said, there are a few signals that can help identify a bubble.

1) Everyone around you is talking about it

You should start worrying if everyone is talking about the fad asset of the day, and the people getting rich lack an expertise in that area.

As an example, back in December 2017, everyone was talking about cryptocurrencies at my office. No matter where I went, the discussion was cryptocurrencies. When I turned on the news, the headlines were how much Bitcoin had increased to, and at one point how the founders of Ripple, another cryptocurrency, were worth more than the founders of Google. This was a sign that the market was reaching a peak. Soon after, cryptocurrencies hit a market cap of $795 billion, before plunging to $134 billion as of January 4, 2018, a drop of 83.4%.

2) When you see extreme predictions

When you see others being overly optimistic, it is a sign the market could be a bubble. Market moods follow but do not predict returns. Investors typically get optimistic after markets have done well, and become pessimistic after markets have done poorly. Essentially buying high and selling low. This is the opposite of what you want to do. You want to buy low and sell high!

In 1999 for example, the best-selling book was Dow 36,000 before the market crashed (the Dow is currently at 25,000 at the time of this writing). In 2017, some predictions were that Bitcoin would hit $100,000 in 2018 and then the crash happened soon after.

3) When fundamentals are ignored

Cryptocurrencies have no fundamentals. It is a digital creation. It does not produce income and to date has not become easier to use than traditional methods of payments. It is more environmentally unfriendly; suffers from lack of trust from hacking, and operates in an unregulated grey zone.

Warren Buffett is quoted as saying:

“Bitcoin has no intrinsic value. I don’t know what it is. But it has no intrinsic value in our definition of intrinsic value. If someone else wants to speculate on it or invest in it, it’s for them. It’s not for us.”

“If you buy something like bitcoin or some cryptocurrency, you don’t have anything that is producing anything. You’re hoping the next guy pays more. And you only feel you’ll find the next guy to pay more if he thinks he’s going to find someone that’s going to pay more.”

Bill Gates:

“As an asset class, you’re not producing anything and so you shouldn’t expect it to go up. It’s kind of a pure ‘greater fool theory’ type of investment,”

“I would short it if there was an easy way to do it.”

Like with the tulip bulb mania, the South Sea bubble and the dotcom boom, the collective insanity around cryptocurrencies should make you wary and to stay away.

4) Significant overvaluation

Cryptocurrencies are hard to value because they do not have intrinsic value. Their worth is only as much as what the next guy is willing to pay for it. Looking at the chart below you will see the boom and bust of Bitcoin, the first and largest cryptocurrency by market cap.

From the beginning of 2017 to the end of 2017, Bitcoin rose from $1,000 to $13,800, and from the beginning of 2018 to now, is down 72% to $3,900. Anything that can fluctuate that wildly was overvalued.

What Should You Invest In?

In my book, Kicking Financial Ass, I advocate a systematic, index fund based approach to investing. It has been proven to be the most effective way to make money in the stock market over the long run and the best method for earning yourself a retirement nest egg.

However, if you are still interested in purchasing cryptocurrencies (I did not use the term ‘investing’ as investing means buying an asset that creates value), or any other speculative asset of the day, use money you are willing to lose, and keep your purchase a small portion of your overall portfolio.

Legal Disclaimer: The views expressed by Mr. Dumont on Money Sensei are solely his and not intended as investment advice nor a guarantee of any financial return. Mr. Dumont is not an investment or tax professional, so the information contained on the blog is not a substitute for professional advice. The contents of this blog are accurate to the best of his knowledge at the time of posting, but rules and laws are ever-changing. Please do your research to confirm that you have the current information.

Also note: As an Amazon Associate I earn from qualifying purchases.

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