Updated: Sep 8
Barely six weeks into 2018 and already it seems that heightened market volatility could well make it the year of the big one. While still a ways from crash territory, the sell-offs seen in the Dow and S&P500 in the first week of February–both plunging some 10% from their January highs–may well prove to be harbingers of market conditions to come, as the growing inflationary pressures raise the odds of more central bank monetary tightening.
However, in the event of any major correction it would be the cryptocurrencies that blazed the trail. By the first week of February, bitcoin had already plunged 70%, pulling other virtual currencies down with it, and making it easy to forget that a mere 12 months ago it had hovered around $1,000 before starting its meteoric ascent to peak at $19,343 back in December 2017.
In my article back in October (why it may not be long before bitcoin is short), I argued that the eventual launching of the bitcoin derivatives market would likely have a sizeable impact on its price behaviour. While that certainly appears to have been the case, bitcoin's volatility has been such that it is virtually impossible to ascribe causality to any one individual factor.
What cannot be denied, however, is that the sudden flood of negative media coverage once the market had started to turn played a major role in further eroding confidence and accelerating the decline. Indeed, so soon after unequivocally declaring cryptocurrencies as the next big revolution, media outlets were suddenly falling over themselves to be first to report on their failure, as if overcompensating for being late to the crypto caravan. From rumours of price manipulation on major exchanges and outright crypto theft by hackers, to knee-jerk regulatory changes designed to limit competition with government backed currencies, the frequency (and urgency) of the headlines all but guaranteed bitcoin's bear trend would transition to a virtual free-fall, with other major cryptocurrencies litecoin, ripple and ethereum following suit. The infographic below provides an overview of the carousel of negative headlines that most rocked the crypto markets in recent weeks.
Cryptocurrencies: not your typical bubble
In line with the gloomy sentiment outlined above, prominent economists and large financial institutions have been predicting that bitcoin and other cryptocurrencies are on their way to zero now that the bubble has burst. But perhaps this hastily-reached conclusion assumes that bitcoin neatly fits into the classic definition of a bubble in the first place, thus making it worth brushing up on definitions and lessons from history.
According to investopedia, bubbles are typically defined as economic cycles characterized by rapid escalation of asset prices followed by a contraction. They are created by a surge in asset prices unwarranted by the fundamentals of the asset and driven by exuberant market behavior. When no more investors are willing to buy at the elevated price, a massive selloff occurs, causing the bubble to deflate.
While bitcoin's recent price swings tick many of these boxes, there are at least two fundamental reasons why it may well be too early to write off crytocurrencies as a typical bubble. First, although overall levels of retail participation are growing rapidly, they are likely still far below those seen during the dotcom bubble of the 1990s when the volume of retail investors buying into the belief that they could flip dotcom stocks at higher prices in the short-term was huge, resulting in a feeding frenzy that eventually brought the market to its knees.
In contrast, the numbers of cryptocurrency investors are not as high as one would be led to believe given the hype. For example, looking at the total number of blockchain wallets in existence and dividing that by the total global adult population with access to bank accounts yields a figure of 0.4%-0.5% hypothetically possible participants. So although bitcoin is by no means immune to the negative feedback loops that inflate bubbles as outlined above, the fact that cryptocurrencies and blockchain technology are still in their infancy strongly suggests that a genuine retail investor-fuelled bubble either won't happen for some time, or in the case of bitcoin, won't happen at all given its controlled supply of 21 million.
No method of valuing a bitcoin
Secondly, the very nature of a bubble necessitates a gulf between an asset's perceived value and its fundamental (or intrinsic) value. However, much of the faith people put into bitcoin is based on the idea that it represents the heralding of a new technological age that promises to reconfigure our methods of transacting, update our mediums of exchange, and deliver new ways to invest, and for many, this justifies the high prices being paid. In other words, much of the value of bitcoin is fuelled by emotion, which does little to help us determine how to value it, or how it compares and relates to traditional currencies, commodities, and shares.
"We tend to overestimate the effect of a technology in the short run and
underestimate the effect in the long run." - Roy Amara
This mix of excitement and novelty surrounding a new and little-understood technology culminating in soaring asset prices bears much in common with the dotcom bubble, when the various methods of measuring stock value were deemed outdated and inadequate because 'the internet was going to change everything,' resulting in many NASDAQ-listed stocks sporting P/E ratios as high as 300. Yet the key difference is that tried and true methods of equity analysis exist to calculate the intrinsic value of a share of a company, whereas no single accepted valuation method exists for bitcoin, making any direct comparisons to previous stock market bubbles meaningless. This is precisely why one constantly hears bitcoin value estimates that range anywhere between $50,000 to $1,000,000, the majority of which are baseless.
Where do we go from here?
Despite the carnage of the last few weeks, my personal view is that the likelihood of bitcoin going to zero is very low given the amount of latent momentum this market has amassed over the past year. Further, taking a look at the long-term technical picture shows that in November 2013, bitcoin peaked at around $1,124, before correcting all the way to $177 just over a year later, a decline of 84%. Naturally, because these moves were smaller in nominal terms and because bitcoin had not yet attracted the mainstream media spotlight, it meant that these crashes and subsequent bear trends caused less of a stir.
Regardless, however, the pattern of sharp price spikes and equally large declines followed by a resumption of the upward trend has happened repeatedly over the last five years, and the probability that this pattern will continue is high. When the gold bull corrected back in 2012 at around $1,800 an ounce, the smart money value investors waited for inexperienced investors to bleed out before buying in at $1,100, and the same could well be on the cards with bitcoin.
Where will we be in another three to six months and beyond? In short: no one knows. What is certain is that be it bitcoin, litecoin, ripple, or perhaps indeed an entirely new crop of digital currencies–and more importantly the blockchain technology that underpins them– are here to stay, and the shrewdest move is to sit back, watch, and learn.
The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.