Is Bitcoin in a bubble? — Signs to watch out for…
Cyptocurrency seems to be the most talked about in financial topics in the recent years. No doubt it’s a breakthrough in financial technology, but is there too much hype today? Is it in a bubble that is going to burst in the near future? We have all seen how much Bitcoin prices have soared over the years, is this going to continue?
To determine if Bitcoin and other cryptocurrencies are indeed in a bubble, the best way is to look at the history of bubbles. Financial bubbles are created by a sharp price appreciation to unsustainable levels. And unsustainable means the assets far exceed its fundamental value by a wide margin. It is due to the speculative demand, rather than the intrinsic worth, fuels the inflated prices, and sooner or later, the bubble eventually pops and the massive sell offs will cause that dramatic price declines.
There always have been and there always will be financial bubbles. Because of the emotional reactions of the market, greed and fear will always drive the prices up and down in an irrational manner. It can happen in all kinds of investment vehicles, take a look at the past bubbles:
- 1637 Tulip Bulb Bubble
- 1720 South Sea Bubble
- 1980s Japan Real Estate Bubble
- 2000 Dot Com Bubble
- 2008 US Subprime Real Estate Bubble
However, these speculative bubbles are very hard to recognise while happening, you just never know where’s the top, but it will seem obvious after they burst.
So do these bubbles share similarities? A lot.
They all have the same story. Hype, greed and fear. As long as humans are involved, there will always be bubbles. Human nature will never change. This is probably the most reliable indicator that we can tap on to study how future bubbles are formed. So let’s look at some of these bubbles in detail.
1634–1637 Tulip Mania
This is probably the one of the first bubbles in known history. Back then tulips are status symbols of the rich and the rare cultivars of tulip bulbs are prized possessions and their prices rapidly increased in 1634 and people who bought those bulbs early became very rich overnight. And here comes the same story, these windfall stories spread like wildfire and everyone wanted to become wealthy just like them. Greed! And everyone wants to buy tulip bulbs.
This further drove the prices to crazy levels. A single tulip bulb was selling at prices equivalent to $75,000 today! It was madness and people are willing to trade 5 acres of land just for a single bulb. Because they knew and they bet that there will be someone else who was going to buy it at a higher price. It’s the greater fool’s theory in the making, and that created the bubble.
In 1636, tulip bulbs got mainstream and there were tulip futures traded on the Amsterdam stock exchange. All sorts of vehicles appeared, there were even option contracts created and traded on tulips, and enabled people to trade using high leverage and borrowed money. And that fueled the prices again to even more insane levels.
And in 1637, people started to realize how insane the whole situation is and the psychology changed quickly. People became rational, they woke up wondering why they are trading their life savings over these bulbs. And the bubble popped, nobody wanted to buy tulip bulbs anymore and the mass selling began.
The initial steep plunge in prices sent fear into the masses and accelerated the selloff. Prices fell 90% in 6 weeks and triggered an economic depression in the Dutch economy. People who went in at the top lost everything they had. This is perhaps the first recorded or first ever financial bubble history had witnessed. So does history repeat itself? You bet.
2000 Dot Com Bubble
More recently, we have a well known bubble the Dot Com Bubble in 2000. Same movie, different actors. The rise of the Internet created opportunities for businesses to operate at scale. Internet companies are the wave of the future and dubbed the “New Economy”. Everyone can now own a computer and connect to a network of computers.
So any company with a “.com” saw its prices when crazy. Any initial public offering of dot com companies saw their prices increased by ten folds overnight, some from $20 to $650 in the matter of hours! But the truth is most of these .com companies, they are not making any profit and many were in fact losing money. But speculation and greed drove the prices higher everyday.
Dot com stocks were thought by many is the way to get rich. They ditched the traditional fundamental analysis, no more P/E ratios, no more cashflow analysis. Bankers and analysts were saying times have changed and we are in the new era. It was all about new metrics like “clicks” and “visits” to justify higher prices. As more investors became rich, more people were drawn in. Even the “common folks” like the waitresses and the taxi drivers were all into investing.
Between 1995 to its peak in 2000, the Nasdaq index rose by 400%. It became unsustainable and when that happened the plummet began. By the end of 2002, the index fell by 80% with 150 of its 280 stocks lost 80%-95% in valuation. It was a bloodbath. People who got in late lost all their savings. It was the exact same story like the Tulip mania that happened 360 years ago!
More bubbles have happened since, like the 2008 subprime real estate bubble. The same story had appeared again and again over time. So the question is, can we observe the same patterns to spot a bubble? Is cryptocurrency or Bitcoin in a bubble that is going to pop anytime soon?
There are 7 signs that we can watch out for in a bubble.
Sign #1: Prices rise far beyond its Fundamental Value
When prices rise far beyond an asset’s intrinsic value, it becomes unsustainable. Intrinsic value refers to the asset ability to generate revenue or perceived psychological value. And if the asset makes $100, then the value should be around $100. It does not make any sense why this asset is going to worth $1000 or $2000.
Watch out when prices go parabolic, or very steep increase. It is likely to be driven by hype and greed when many people are trying to buy into a stock and paying crazy prices for it. As history has proven itself, prices will always gravitate back to its intrinsic value.
Sign #2: People say “This time is different”
When you hear news and stories about why “this time is completely different and normal rules of the financial market no longer apply.”, it is a sign of irrational behaviour. They are overly optimistic about the future performance of the asset class and justify their investments with weird logic. A common reason is “Revolution” or the “new era”.
Another way is to spot illogical charts and trends. When people say Tesla has a market capitalization equivalent of the nifty nine carmakers in the world but yet, they have only sold less than 1% of the cars compared to them. It just didn’t make sense. I would personally say Tesla stock price is probably in a bubble today with a price to earnings ratio of more than 1192x.
Sign #3: The common folks are all talking and investing in the stock market.
“If the shoe shine boys are giving stock tips, then it’s time to get out of the market.” Joseph Kennedy 1929.
When the housewives and the janitors are joining the buying frenzy, we can be sure that it’s a bubble. Because amateurs and people who have little to no background knowledge get drawn into speculating for the “fear of missing out” or “quick profits”. They are just following the masses and have no idea what they are actually doing.
Sign #4: The Media is filled with stories of high returns and overnight millionaires.
When the media shows how ordinary people with no financial background have become rich overnight, it’s a clear sign of hype. And these media motivates a lot more people to join the buying frenzy and hence sending the prices up to unsustainable levels.
Sign #5: Increased use of leverage by speculators
When greed is at its peak, people look at borrowing money to fuel more profit returns. Because they see amateurs achieving higher than average returns, it entices speculators to start borrowing money as prices seem to safely keep going up. It seemed like a no brainer not to invest. And when speculation with leverage reaches new highs, it’s usually a sign of a bubble.
It is especially so when we see new vehicles to help more people trade them, like new futures, options contracts.
Sign #6: Investing is the talk of the town
When everyone around you, whether at work, on the commute in a family gathering is all talking about how great a particular type of investment is, it’s time to worry! They are all talking about quitting their day jobs and becoming full time investors in certain areas of the market. We see these in past bubbles. In 1637, everyone talked about tulips. In 1998, everyone talked about tech stocks and in 2005, everyone talked about real estate. Is everyone talking about cryptocurrency today?
Sign #7: You just don’t get it!
When doubters are disregarded as people who “don’t get it” and are “crazy for missing out”, it’s a sign. When skeptics are put down vehemently, its a sign of a bubble. People are “drunk”, people are in mass hysteria and thats when the bloodbath is about to begin.
What makes bubbles so dangerous is we often don’t realize when we are in one, as investors find ways to convince themselves that market prices are justified.
So is Bitcoin and cryptocurrency in a bubble?
By looking at these warning signs, we can have a good idea if a bubble is actually forming:
Has prices rise beyond its fundamental value?
Bitcoin and other cryptocurrencies are more tricky when it comes to intrinsic value because they are not productive assets. They do not generate profits, they have psychological value. And it’s very subjective to different people.
What about the charts? If you look at the long term charts, bitcoin prices indeed look parabolic. But its hard to pick the top. On a shorter time trend we do see healthy retracements and support levels. So its hard to say bitcoin is in a bubble from this perspective.
How about the public sentiment?
Well we do often here about common folks talking about bitcoin and finding ways to invest in bitcoin. Almost every other day we hear news about bitcoin, amateurs becoming millionaires. And this is definitely a worrying sign.
Has it become the talk of the town and highly leveraged?
Well yes. For myself, my family dinners often have topics on cryptocurrency, my relatives were asking about how they can invest in bitcoin. Were doubters put down? Is Bitcoin in a bubble? I do smell one.
I personally believe that Bitcoin is in a bubble. But I may be wrong or very wrong. But here’s the thing, if I don’t believe in something, then I don’t deserve making money from it. I believe that well deserved money made should come from things that you truly believed in and have deep knowledge in it. So it’s completely fine with me if Bitcoin goes on to new highs. I don’t deserve any profits in Bitcoin.
Whether you are into Bitcoin ot doubting Bitcoin, always invest on the safe side. A diversified portfolio across all vehicles such as stocks, trading, forex, cryptocurrency, real estate is a foolproof way to mitigate the risks. Never put all your eggs in a single basket. Because the bulls and bears make money, but the greedy pigs are the ones that are slaughtered.
Happy investing everyone!