Will the bitcoin bubble burst?

The cryptocurrency craze is getting crazier. The price of bitcoin, under $1,000 a year ago, hit $6,000 in mid-November and had crossed yet another major milestone – $10,000 – by the end of the month.

A $1,000 investment in bitcoin in July 2010 would now be worth more than $200 million. Has there ever been a bubble like bitcoin?

The bitcoin boom is often compared to the dotcom bubble in the late 1990s, but there is no comparison. The Nasdaq telecom index soared over 700 per cent between 1995 and 2000 but bitcoin has risen tenfold in 2017 alone and has averaged annualised gains of over 400 per cent since July 2010.

The volatility in bitcoin prices is five times greater than that seen at the height of the technology bubble. In fact, almost no bubble in history can compare, according to New York-based Convoy Investments.

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The 1990s tech bubble, the 1980s bubble in Japanese stocks and property, gold in the 1970s, US stocks in the 1920s, even the infamous South Sea bubble of 1720. None of them saw gains as large as bitcoin’s. Bitcoin’s advance dwarfs all but one bubble in financial history – the Dutch tulip mania in the 17th century.

End badly

A whole host of prominent names, including Warren Buffett, hedge fund managers Howard Marks and Ray Dalio, JPMorgan chief executive Jamie Dimon, and Nobel economist Robert Shiller, have warned bitcoin is a dangerous bubble that will end badly.

At the same time, it is receiving increased attention from professionals. CME Group plans to offer its customers the ability to trade futures contracts for bitcoin, with trading expected to commence this month. One fund run by Bill Miller, who famously outperformed the S&P 500 15 years in a row before things went badly wrong during the global financial crisis, reportedly has 30 per cent of its assets in bitcoin, with Miller saying the cryptocurrency is a "technological experiment that may or may not prove to have any long-lasting value".

Billionaire investor Michael Novogratz reckons bitcoin could hit $40,000 in 2018 and plans to launch a $500 million cryptocurrency fund.

In July, Ritholtz Wealth Management chief executive and Reformed Broker blogger Josh Brown said he had bought bitcoin as a personal investment. In the same month, Fundstrat founder Thomas Lee became the first major Wall Street strategist to issue a bullish report on bitcoin. Swiss giant UBS says blockchain, the technology underpinning cryptocurrencies, is "likely to have a significant impact in industries ranging from finance to manufacturing, healthcare and utilities".

Problematic

Still, some arguments advanced by bitcoin supporters appear problematic. Jeroen Blokland, a portfolio manager at Robeco who owns bitcoin in his personal account, admits there is no substance to the idea that bitcoin is a “kind of digital safe haven or digital gold”. The correlation between gold and bitcoin is “very close to zero”, indicating they are “two very different creatures”.

Similarly, massive volatility, high transaction fees and unresolved questions regarding safety mean bitcoin is a long way from being accepted as a reserve currency.

Bitcoin faces competition in the form of other cryptocurrencies, cautions Dr Shane Oliver of Melbourne-based Amp Capital, who notes there are already more than 1,000 such currencies. Furthermore, governments are “unlikely to give up their monopoly on legal tender”, he cautions, adding that regulators are also likely to crack down on bitcoin given its use for money laundering and unregulated money raising.

Above all, there is the problem of valuation. Bitcoin is “impossible to value”, says Oliver, because it produces no income and has no yield, meaning it could “go to $100,000 but may only be worth $100”. Therefore, the only way to make money from bitcoin is to find a “greater fool” willing to pay an even higher price than you paid.

Although Josh Brown owns some bitcoin, he echoes this analysis, saying bitcoin “represents the perfect mania” as there are no dividends or earnings and therefore no traditional way in which to value it. The same point is made by valuation expert Prof Aswath Damodaran, who says anyone who claims to be able to value bitcoin is “just making up stuff as he or she goes along”.

Even enthusiasts such as Michael Novogratz concede that “this is a bubble and there’s a lot of fraud mixed in”.

Like all bubbles, higher prices beget higher prices, with increased numbers piling in as the feverish atmosphere grows ever more manic. People entirely unconnected with the world of finance are getting in on the act, with reality TV star Paris Hilton, Hollywood actor Jamie Foxx, former football manager Harry Redknapp and boxer Floyd “Crypto” Mayweather all recently promoting cryptocurrencies.

“Investors in the throes of a speculative mania are always in search of the next way to play,” says Josh Brown. He points to comical examples such as former biotech firm Bioptix, which saw its share price go skyward after it said it was changing its name to Riot Blockchain and abandoning the world of biotech for cryptocurrencies.

"You're now seeing a classic herd mentality that has pushed the entire space into a bubble that is bound to burst at some point," says Bespoke Investment Group, which points to how companies such as internet retailer Overstock.com and mobile payment firm Square were rewarded with soaring share prices after they made cryptocurrency-related announcements.

“If a stock like Campbell Soup decided to announce that it was putting all of its soup containers on the blockchain,” says Bespoke, “it would probably double or maybe even triple!”

Unsustainable?

Academic research suggests a crash is inevitable. Earlier this year, a National Bureau of Economic Research study of stock market bubbles and crashes over the last century noted a crash becomes “nearly certain” whenever a market enjoys an especially rapid run-up (for example, 150 per cent over a two-year period).

However, bitcoin supporters might say: so what? In June, the Economist warned that "ascents this steep are rarely sustainable". Since then, the price of bitcoin has risen fivefold.

Bitcoin’s price trajectory has looked unsustainable for a long time, says Pension Partners’ Charlie Bilello. He notes how bitcoin soared 2,100 per cent between July 2010 and February 2011, going from five cents to $1.10. The price then nearly halved before then advancing another 2,801 per cent, peaking at $31.91 in June 2011.

Another crash ensued and many commentators did postmortems after bitcoin lost 94 per cent of its value. It came back from the dead, however, hitting $266 in April 2013. Another crash followed, bitcoin falling 76 per cent, followed by another astonishing recovery.

By late 2013, bitcoin’s chart resembled the biggest bubbles in history. The ensuing 85 per cent crash indicated the bubble had finally burst, bitcoin falling from $1,166 to $170. Of course, it recovered, exceeding $10,000 last month. The current chart “screams ‘bubble’,” says Bilello, but so did all the earlier charts.

Like all manias, says Josh Brown, people will be “wiped out” when it turns, but players “can make an awful lot of money while the mania grows, before the comeuppance”.

The sceptics may well be right about bitcoin, but timing that “comeuppance” appears to be an impossible task.