The predictability of the Bitcoin crash

It wouldn’t be long before I chimed in about Bitcoin and the collective insanity that currently surrounds it.

If I’m completely honest, I have not yet endured a market bubble whilst I’ve had skin in the game of the investing world. However the current situation of Bitcoin is obvious even to me.

Just like all the bubbles that appeared before it, Bitcoin has entered the stage where the most adamant of supporters are claiming ‘a new paradigm’. That us oldies can’t understand because we are dinosaurs from a time past.

I believe this will end spectacularly.

In truth, Bitcoin may represent the purest of academic bubbles that has ever existed. I say this because I have searched for a rational way to calculate the intrinsic value of a Bitcoin and everything I have comes up short.*

A Bitcoin produces no income and is extremely hard to value. Some even suggest it has a value of zero, which leads to the question…

Why are people buying it?

The answer is simple and yet it will raise plenty of objection.

It is pure speculation.

There is a relatively small number of people that really believe in the underlying technology and future of cryptocurrencies. I would also care to say that many of these people believe in the technology without really knowing much about the technology, i.e. Blockchain.

These are the first group of people buying up Bitcoins and other cryptocurrencies. They believe that these cryptocurrencies will have such great utility in the future, that the prices today are justified.

There is another group of people that have seen the astronomic rise in Bitcoin prices on the news and have come in to play their hand at the greater fool theory.

Both of these are positions of speculation.

I’ll admit, some speculation about the future value of assets is OK, as people try to judge the potential of an asset in the future.  But here is the issue with Bitcoin. Too many are conflating the utility of the Blockchain with the utility of any one cryptocurrency.

Blockchain is extremely useful, with applications in fields such as finance, research and distributed computing. However the value of any individual cryptocurrency is much harder to judge, because they are highly replicable. Thousands of new cryptocurrencies are hitting the market precisely because any teenager with a rudimentary knowledge of coding can take the open source code for Bitcoin off of Github and create a new cryptocurrency with about a day’s worth of work.

So with many very similar competing ‘products’ and a very low barrier of entry to a competitor creating a new ‘product’, where does that leave the value of these things we call cryptocurrencies?

I believe we are left right back at the beginning. Bitcoin has the price that we give it. Which is just another way of saying Bitcoin’s price is based purely on the speculation of market participants.

Now that I have said this, let me add…I do believe you can make money from speculation. That is obvious from all of the bitcoin millionaires we are now hearing about.

I also believe there is a place for blockchain technology in the future.

I merely wish to comment on the speculative bubble that I am witnessing right now.

The anatomy of a speculative bubble

Below I am going to show you Jean-Paul Rodrigue‘s Stages of a Bubble chart, first developed in 2008 long before cryptocurrency existed, let alone had the attention it has today.

STAGES OF A BUBBLE

You can compare this graph to the real valuation graphs of any bubble in history and find uncanny similarities.

I will now show you a chart of the price of Bitcoin since the start of 2017.

It’s a fun game of try and spot the difference really.

As I take one step further and overlay the graphs below, the similarities become undeniable.

I have had to stretch the original ‘Stages of a Bubble’ graph a little to make it fit, but there is no quantitative y-axis scale so that manipulation is perfectly within reason.

If this doesn’t scare the hell out of you, then I don’t know what will. In my opinion, this bubble has a ways to go before valuations reach a more reasonable level.

If you are in the group that is trying to jump on the money-making bandwagon, you’re likely motivated by the idea of making some quick cash, hoping you won’t end up being the greater fool. I just feel it is important to realise that is what you are doing.  It is analogous to gambling.

If you are in the group that believes cryptocurrencies will eventually take over the world and the current valuation is justified, then nothing I have written here will change your mind.

The temptation to earn quick money is high, particularly when you have such an exciting goal such as financial independence to work towards. I say it is much better to avoid the trap of believing you can make some quick money. That is a strategy much like playing the lotto. A few people win and get massive media attention, but you never hear about the majority that lose. Even those that win often end up wasting it all because they never learned how to manage their money through the long tough slog of building wealth slowly.

Much better to work with the rock solid reliability of ETF investing, I say. Diversified, income-producing, intrinsically valuable organisations that will always see you increasing your wealth in the long term. They are a sure path to getting you to where you want to go and teaching you the lessons you need to learn to maintain that wealth when you get there. If property is more your game, I won’t begrudge you that opinion.

Shuffling 

Pat the Shuffler

*It is true that there may be a way to calculate the fair value, but I believe if it is this hard for me to find it, then it is likely that it is just as hard for most of us to find the fair value of a Bitcoin. I say this not having any coding experience.

19 Replies to “The predictability of the Bitcoin crash”

  1. First, I agree that Bitcoin is hard to value, and it may be in a bubble. It could easily fall to near zero. Where I don’t really follow the logic is using an essentially technical charting approach pattern recognition approach to evidencing this.

    This seems a bit like disproving witchcraft with a ouija board.

    By this, I mean that Rodrigue graphic has been scaled in time, and in value, to match the two curves. For example, the graph starts in 2017 – but why should this be so? Why not start it somewhere else? Note also this pattern also would have been found in the dozens of run ups and declines for years before 2017? So the same curve would have consistently misidentified a final decline on each of those occasions.

    Note I’m not making any particular claim about the value or future of Bitcoin at all. I’m only saying that curve fitting graphics don’t provide solid evidence either way. My concern is that Rodrigue finding an abstract curve, and applying it to a market event, might easily be confirmation bias.

    1. Hi Fiexplorer

      I agree that the evidence isn’t particularly strong for the reasons you have stated. However scaling the size of that graph is completely reasonable, it has no quantified scale. Though I grant confirmation bias may very well be at play here.

      The run up could very well continue.

      I would suggest that all of those previous times where the chart fit may have also have been bubbles that popped and returned to ‘normal’ before the next bubble began again.

      I think I more wanted to show that we have seen this behaviour before and it matches what we recognise to be and what we have given the title of ‘a bubble’. We don’t actually need a comparative graph to tell us that, it just helps those who aren’t familiar with speculative market bubbles to visualise what I am saying.

      Something about history rhyming also comes to mind.

      1. Fair enough. To me, the media reports of people borrowing to buy Bitcoin is much more compelling evidence of a mania, it certainly showed lots of the signs,, so I’m not saying you’re wrong at all. I guess I had thought of a speculative bubble as implying a tulip bulb like permanent return to near zero. If we say as above that Bitcoin can go through multiple ‘bubbles’ on the way up to a higher value, we face the problem of someone saying that that also applies to the sharemarket. For me at the moment, Bitcoin could in some ways be compared to an option, or equity in a very speculative start up, which is not to say it is not high risk, or an extremely long shot in a crowded field.

        1. It may be a permanent return to zero. In the long term I find that the most rational eventuation. I can state reasons why I think it will happen but we can save that for another post 🙂

          It definitely does also apply to the sharemarket and property. But shares and property have value even if nobody in the world wanted to buy them, so you can ride out the bubbles confidently. On the other hand Bitcoins only value is based on speculation.

  2. Investing in bitcoin because you’re a believer in the technology is like backing the dog out of the red box in the first at Dapto because you’re a believer in the quality of the nutrients in its food. You’re kind of on the right track, but missing the point.

    Bitcoin investing would constantly mess with your balance in a portfolio and it definitely won’t be part of mine… at least not intentionally. I can’t find one creditable investor who says it’s time to get some bitcoin into your portfolio. Till then, I’ll watch happily from the sidelines while my investments take 5% hits in a week and that’s considered front-page news!

    1. I echo those sentiments, though just wait until the share market takes a proper tumble and it is front page news for a year!

    2. Investing by by the punters is based on strong beliefs (based on dreams about unearned wealth) which periodically fall apart in a market correction/collapse. Those who profit don’t believe, they know (usually by way of some form of insider knowledge or privilidged access allowing them to front run trades or markets). There is always dumb luck too. Re ETFs, if one was invested in the Australian market in 2008 (peak of 6800) one would still be underwater, ie history is memory is hopefully perspective. ETFs invested around the world are not really investments, they are institutionally sanctioned speculation where the funds’ managers always win and retail investors sometimes win, sometimes lose. One can not call putting money into these entities ‘investing’ when the main global markets are propped up by central bank money printing, central bank securities purchases (Japan), interest on junk bonds kept at historic lows by central banks etc, etc. Price discovery is dead but I suppose some people feel obliged to dance while the music is playing. Good luck anyway.

      1. Hi Chris, I just wanted to point out that if you take into account dividends aswell as the capital in the all ordinaries, investors have been returned more than all their value since the GFC.

  3. I’ll raise one minor point. The problem with the Stages of a Bubble chart in relation to Bitcoin is that there is almost no institutional money invested in BTC.

    1. That may be a problem with the chart, but even more a strike against cryptos. Do you think there ever will be major institutional investment?

  4. Two worlds collided today… the guy who blogs at Greater Fool (www.greaterfool.ca) addressed the bitcoin issue in his latest post, specifically the similarities between investing in shares and bitcoin. Spoiler alert: there aren’t any.

  5. I won’t be writing about it, as I don’t deem it important enough to warrant any commentary. Perhaps a few musings on the human psychology of it all is interesting, but that’s about it.

    When soccer mums and taxi drivers get in on it without having ‘invested’ in anything else before, there’s something wrong.

    The technology and the ‘currency’ aren’t the same thing, many believers ignore that. Now the mantra is it’s a store of value like gold. It can be whatever they want it to be, but I’m not interested.

    I’ll happily stick with boring, long-term investing for cashflow with Buffett and the other dinosaurs!

  6. People forget what is currency. I have argued with Bitcoin enthusiasts who say that fiat currency has no intrinsic value. They deliberately forget that a nation’s currency is backed by that nation, and needed for trade with that nation and paying taxes in that nation. Tradable frequent flyer points act more like currency than Bitcoin. Fiat currencies only become worthless once a nation collapses. Bitcoin is the purest definition of speculation. At least with Sydney houses you get some shelter for your money. With poppies you get a pretty flower. With Gold you get something of industrial value. Bitcoin is a digit in the cloud and a vain hope there’s a greater fool out there.

  7. As one of the ‘relatively small number of people that really believe in the underlying technology and future of cryptocurrencies’ I cringe whenever I see the Stages of a Bubble chart used as an argument.

    In your graph overlay it would indicate that Bitcoin will return to the mean ($3000 on your chart) – but people have been matching bitcoin prices using this chart since bitcoin was $100. I’m not saying it won’t go to near 0 (it’ll always be a collectors item for some – I sold my 90’s tazos I got in chip packets last year for example), I’m just saying the Bubble chart is meaningless and can be matched in some time frame to many, many assets.

    You don’t really have enough knowledge to talk about cryptocurrencies, this is obvious with your statement about them being highly replicable. A replicated bitcoin doesn’t have the security of bitcoin and this security is one of bitcoins values. If you want to understand more about how cryptocurrencies could be valued I suggest first reading up on Proof of Stake. Consider current and possible future transactions on the Ethereum blockchain and that each transaction has fees involved and that you can receive these fees by staking ether (the ethereum token). You’re essentially paid dividends and you can model a price per token based on transactions/amount staked/inflation/circulation etc.

    I think crypto can be a balanced part of a portfolio, obviously you should understand what you’re investing in and know the risks. 14/02/18 – eth at $864 OMG at $14.19 (USD). Make a note to check back when you reach your goal at what these numbers are!

  8. Hi Pat the Shuffler,
    Here’s a few extra tips for creating and retaining wealth you can retire on.
    1/ Don’t enter into a relationship for more than a year. The penalty is half your assets if it goes wrong.
    2/ Never buy a new car. If you need to, buy a secondhand unfashionable but reliable vehicle with less than 100,000 km on the odometer.
    3/ Never invest in property unless you have 100% control of the property.
    4/ Watch out for management fees in any investment vehicles. Some are designed to bleed investors dry.
    5/ Avoid agrarian schemes. Crops fail, timber dies – there are dozens of excuses for investors to lose their shirts.
    6/ Buy gold and platinum – not as an investment, but as a currency hedge. Put it in a drawer and forget about it for 5 – 10 years.
    7/ Consider emigrating once you have reached your wealth goal. $40,000 income won’t go far in Australia now, or even less when you have reached retirement. It will go a lot further in places like Thailand, Vietnam and the Philippines.

    Good Luck.

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