When Grandma and Grandpa join the bitcoin frenzy, you know it's turning into a bubble

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This was published 6 years ago

When Grandma and Grandpa join the bitcoin frenzy, you know it's turning into a bubble

By Michael Hiltzik
Updated

One day in 2013, when the price of bitcoin had crashed to $US600 from $US1,200 in a matter of hours, I wrote that this showed that the virtual currency was a dumb investment.

Three months ago, when the price hit $US5,000, I again called it a dumb investment.

So what about now, with bitcoin trading at about $US10,000?

Yes, it's still a dumb investment. In fact, dumber than ever.

The more mainstream bitcoin becomes, the greater the risk is of a sudden price fall.

The more mainstream bitcoin becomes, the greater the risk is of a sudden price fall. Credit: Bloomberg

To bitcoin's faithful, this is a ludicrous statement. They ask: How can an asset enjoying a parabolic rise be a dumb investment, especially as it is increasingly accepted by major financial institutions?

Just Thursday, the Big Four accounting firm PwC said it had accepted bitcoin as payment for services for the first time. On Friday, the Commodity Futures Trading Commission approved bitcoin futures to be traded on the Chicago Mercantile Exchange and the Chicago Board Options Exchange Futures Exchange. By providing a semblance of regulatory oversight as well as an efficient means for shorting bitcoin, those markets could make bitcoin more palatable for financial traders by bringing it at least nominally into the regulatory spotlight.

The glass half-full approach

Other plausible rationales for a continued price rise exist. "A lot of institutional investors haven't entered the space," says Matthew Gertler, a Los Angeles-based analyst at Digital Asset Research, which advises investment clients on the complexities and peculiarities of bitcoin and other so-called cryptocurrencies. If these investors flood into the market, the price will rise.

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Moreover, Bitcoin still accounts for a tiny proportion of global financial transactions; the worldwide stock of "broad money," which includes notes, coins and financial accounts, was placed at $US82 trillion ($108 trillion) by the CIA as of the end of 2016. At a price of $US10,000, the market capitalisation of the current worldwide supply of bitcoins is $US167 billion, ranking just ahead of the Venezuelan bolivar but well behind US dollars, which were valued at $US13.2 trillion. That suggests the market still has room to grow.

There are many sound theories about why bitcoin will keep going up - or crash back to earth.

There are many sound theories about why bitcoin will keep going up - or crash back to earth. Credit: Rick Bowmer

Yet bitcoin bears all the signs of a bubble. Its price has run up by roughly 1,000 per cent this year, reaching more than $US11,000 Wednesday before backtracking. That price seems divorced from the value of any underlying commodity - in fact, there is no underlying commodity. Its promoters talk as though it's destined to keep rising forever, even though it's experienced an inordinate number of hair-raising plunges since the first exchanges began operating in 2010.

Bitcoin now has started to grab the attention of the average punter - the Wall Street Journal is running articles about grandmas and grandpas looking for ways to buy in and students debating bitcoin over their Thanksgiving turkey. That's another red flag that speculation may be getting out of hand.

If you invest in bitcoin, expect volatility.

If you invest in bitcoin, expect volatility.Credit: AP

Bitcoin's 2017 price rise has outpaced almost all the great bubbles of the past. The dot-com market ran up by a bit more than 500 per cent before crashing in 2000, Japanese stocks about 300 per cent in the 1980s. Shares of the South Sea Co. - the emblematic South Sea bubble - inflated by only 10 times before crashing in 1720. The only investment craze that has outpaced bitcoin thus far is thought to be the Dutch tulip mania of the 1630s, though exact price comparisons are hard to come by.

'Not an easy call'

When will the bubble burst? That's hard to know. Some prognosticators, including experts in investment manias through history, think we're on the verge of a peak or even just past it; others observe that bubbles can keep inflating for months or even years before bursting.

People aren't buying based on any fundamental knowledge of the product

Investment commentator Mark Hulbert

"It's not an easy call," says Lorenzo Di Mattia, manager of a global hedge fund at Sibilla Capital Management and an aficionado of investment manias of the past. Compared to the timeline of the dot-com bubble of the late 1990s, which ended in tears in 2000, he says, "the question is where we are - in 1997, or the beginning of 1998 - or 2000." But he believes it's "too early to call an end to this." The Nasdaq market bubble inflated for about four years before its crash, after all.

The Nasdaq market, however, encompassed not only unprofitable dot-coms erected on speculative quicksand, but also companies such as Microsoft and Intel - "real companies," Di Mattia says. "This is nothing," he says of bitcoin. "This is air."

That points to the most important question about bitcoin: What is it? Boiled down to the essence, it's the product of a mathematical algorithm that's designed to limit its supply to 21 million virtual coins (the supply currently is 16.7 million). It's not backed by a specific asset such as gold or treasury bonds, or by a central bank. To its fans, that independence from government control - indeed, any centralised control - is its greatest virtue because that's what makes it immune from deliberate devaluation by central banks hoping to prop up their national economies.

But to others, that's a fundamental flaw. In approving the futures contracts, Commodity Futures Trading Commission Chairman J. Christopher Giancarlo warned that most bitcoin activity will still take place in "largely unregulated markets." He warned of a "high level of volatility and risk in trading these contracts."

Today, bitcoin functions as both a quasi-currency and a speculative investment vehicle. But the excitement among investors generated by its rapid appreciation this year undermines its value as a currency.

"A currency that appreciates too rapidly is eliminating the main purpose of its existence," observes Howard Wang, co-founder of the research firm Convoy Investments - people will spend money only when they perceive its value as stable, otherwise they'll hold onto it in expectation that it will be much more valuable tomorrow. As recently as last year, some retailers were trying to attract customers by advertising that they accepted bitcoin at the counter. Now, Wang says, "nobody is talking anymore about using bitcoin to buy pizza, only about how they can make money in it."

Novices should be 'extra careful'

But its massive volatility eventually may work against its popularity as an investment. Just after peaking above $US11,000 this week, bitcoin experienced a nearly 20 per cent drop in a matter of hours. That's not all that extreme for bitcoin, but for any other investment, it would be regarded as wildly excessive. The 1929 stock market crash took the Dow down more than 25 per cent in four days and was accompanied by a worldwide depression.

If you find the particulars of bitcoin hard to understand, you're not alone. That's another feature of the bitcoin investment market that has some experts nervous. "What happens in these bubble-ish areas is that you get people trading who probably shouldn't be and who don't understand it," says J.J. Kinahan, chief market strategist at the brokerage firm of TD Ameritrade. "If you can't define what the product is, you might want to be extra careful."

(To use bitcoin, you establish a "wallet" through a bitcoin firm, fill it with bitcoins purchased with whatever currency you have on hand and then you can convert them into a different currency when you wish. These transactions are online, so the asset values can shoot all around cyberspace without touching solid ground.)

Even prominent bankers find it hard to get their arms around the bitcoin principle. "I don't personally see any value in something that has no actual value," Jamie Dimon, the chairman and CEO of JPMorgan Chase, said at an international finance conference in October. "I could care less what bitcoin trades for, how it trades, why it trades, who trades it. If you're stupid enough to buy it, you will pay the price for it one day."

That judgment may have been unnecessarily harsh. The principle underlying bitcoin, known as blockchain, is finding uses in finance and other applications - it's a way of keeping a transaction ledger that can't be secretly altered and remains out of the control of a single entity, enhancing trust in the record.

For now, the rise of bitcoin seems divorced from any fundamental rationale. Investors who bought in before, say, midyear 2017 have made so much money in the market that they could weather a crash of even 40 per cent and still be in the black. Those who have been enticed in at the current stratospheric prices may be living on a knife edge, however.

"People aren't buying based on any fundamental knowledge of the product," says Mark Hulbert, an investment commentator who this week placed the chance of a crash at better than 80 per cent.

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"They're just interested because they see it going up."

Los Angeles Times

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