Bitcoin is the Greatest Bubble in Human History

This special guest commentary was written by our friend Richard Peterson M.D., MarketPsych.

In 2011 a friend of mine - a brilliant college graduate from a top University - worked on hardware and coding projects for MarketPsych.  To save money he lived in his car in Venice Beach, California near our office.  He's a free spirit and technical genius, and in 2013 he set up cryptocurrency mining software on our spare server space.  He accumulated a good deal of coins through his mining.  Needless to say, he no longer needs to live in his car. 

Many of the early bitcoin millionaires are eccentric.  Eccentric in that gloriously liberated, analytical, and creative California-style of Steve Jobs.  Such visionaries can see - and create - value out of nothing.  It's one of the inspiring characteristics of the original bitcoin community. 

We wrote our first and only newsletter on cryptocurrencies when the bitcoin price was still under $100.  After 4 1/2 years and 100-fold appreciation, much has changed in the cryptocurrency world.  And yet, a disturbing amount has remained the same for bitcoin itself.

The biggest winners from bitcoin so far - and for the foreseeable future in my opinion - are the inspired developers, early investors, exchanges, miners, money-launderers, and thieves.  Bitcoin may continue to swell in value, but the future of viable blockchain applications lies elsewhere.

In today's newsletter we examine the benefits and weaknesses of cryptocurrencies, the current bubble, and the psychology driving currency prices.  Note:  I'm not going to tell you which cryptocurrencies I think are best to invest in, nor am I going to tell you when the prices are going to collapse again (it's not uncommon for prices to drop 80-90% from their peaks). 

How Do We Value Belief?

I've seen many rational value investors and financial analysts proclaim that there is no value in cryptocurrencies.  But they are using the wrong toolkit -- analyzing cryptocurrencies with traditional valuation metrics is impossible.  The psychological aspects of valuation contain the key to understanding bitcoins.  Bitcoin's $160 billion market cap IS value.  

Are cryptocurrencies in a bubble?  Yes, definitely.  In fact, they are the greatest asset price bubble in human history.  Bitcoin is a perfectly engineered bubble machine.  Its value is what buyers believe it is.  This is key to understanding the current mania.

The chart below depicts the average daily relevant references to bitcoin in top global financial news and social media from 2010 through the present.  We have surpassed 45,000 daily in November 2017 (see far right of chart).

This is the number of mentions in the media, not price. 

If early bitcoin investors had followed financial advisors' standard advice to diversify (I've sat in meetings where that advice was doled out), they would have a tiny fraction of what they have now.  When belief trumps fear, one can hold the line during price volatility.  

If one is going to invest in cryptocurrencies (or already has), it's very important to understand what one is invested in.  If you don't believe in what you own, then you won't be able to hodl (Hold on for Dear Life) during the inevitable price declines.  Confidence is based on belief, and belief is based on understanding.

Bitcoin's Value: Not speed, Not low cost, Not anonymity

Unfortunately, it's difficult for me to believe in bitcoin anymore.  Bitcoin should be a low cost money transfer mechanism...unless you were moving bitcoin last week, at which time the costs rose to $5-20 per transaction.  Bitcoin should be fast to transfer ... unless you need to wait 24 hours (as also occurred last week) for clearing.  According to a top exchange:  "Bitcoin may not be the ultimate cryptocurrency - for example it has major delays such as transactions requiring at least 10 minutes to be verified and the price is very volatile...."  This WSJ article describes the delays.

These problems are not new, and the bitcoin development community has been too paralyzed by infighting to fix them.  In our 2013 newsletter we noted: "The transaction history of each unit of currency is becoming quite long, leading to delayed transaction times as each unit of coin is reconciled.  Additionally, there may be disputes along the “Blockchain,” leading to forked transaction histories and multiple species of the same currency (although this has not happened yet)."  These problems still exist.

Other problems with bitcoin:  

1. There are four mining pools providing half of Bitcoin’s capacity (and making it more susceptible to majority attack).
2. There are numerous, and often confusing, blockchain forks.  Bitcoin Cash is perhaps the most viable, but it also dilutes the brand.  
3. Bitcoin transaction speed falls far behind bank transactions, and it cannot be fixed in its main branch. 
4. Use of bitcoin in daily transactions is not increasing.  Per this article:  "The number of bitcoin transactions on a daily basis has been consistent in 2017."
5. By the number of the wallet its owner’s transactions can be tracked, which substantially undermines anonymity.

So the value of bitcoin appears to be centered around its first-mover status, subsequent price appreciation, and the true believers who hold it as store of value (increasing its scarcity).  There are other coins (and blockchain technologies) attracting true believers, and one or more of these are likely to surpass bitcoin over time.

Alt Coins and Smart Contracts

Newer cryptocurrencies get around many of Bitcoin's constraints.  Ethereum is a smart contract mechanism and a currency.  Other groups are working on cutting edge technologies using smart contract derivatives.  Many of these are at the white paper stage with no viable products, and yet almost all hold values upwards of $50 million in market cap.  Here is an interesting analysis of the Ethereum-fueled ICO bubble.  

In this excellent summary, we see a breakdown of companies in the cryptocurrency space:  "Given that beyond financial speculation we’ve yet to see mainstream cryptocurrency use cases, infrastructure development and use cases that are vastly superior for users in either cost, privacy, and/or security in extremely delicate areas (such as identity, credit scoring, VPN’s amongst others) seem to be the most likely candidates to capture significant value."  

Many of the coming technologies are potentially revolutionary, such as Blockstack, whose technology could reorganize the plumbing of the internet.  In a more mundane example, large health care companies are developing blockchain technologies to transfer medical records privately.  Insurance start-ups are creating new pools of insurance arranged online via smart contracts and distributed ledger technology.  As with many new technologies, it's likely that start-ups will make rapid progress in specific fields and have their technologies bought out by established firms without the expertise to create their own blockchain tech.

Yet there are few real world uses currently.  Following after speculation and investment, tax evasion and money laundering are the most common uses of cryptocurrencies.  This may explain the rise of demands for Monero and ZCash (improved anonymity versus Bitcoin) in ransomware attacks.  Governments are naturally concerned.

Government Crackdowns

Governments are not sitting idly as cryptocurrencies rise in value and popularity.  Russia banned all trading except through Russian exchanges (presumably so it can be tracked) and the Russian Central Bank has been one of the most vocal opponents of bitcoin.  China banned all mining and trading in cryptocurrencies in September 2017.  The USA treats bitcoin like an asset, and tax records need to be maintained for every time it is bought and sold (thus effectively prohibiting use as a currency).  This week Coinbase was ordered to turn over information about 14,000 accounts to the IRS.

The FBI, U.S. Treasury, and others seized the servers of exchange BTC-e.  45 percent of all currencies in the accounts were lost.  (Incidentally, if anyone at the FBI is reading this and would be so kind as to release my bitcoin, I'd be very appreciative).  BTC-e re-emerged as wex.nz, issued tokens for the missing funds, and 10-15% of the seized currencies and fiat have been repaid in the 60 days since the seizure.  A similar repayment happened with the exchange Bitfinex after hackers stole funds - the exchange itself repaid them.

Of the large economies, only Japan allows bitcoin to be used as currency.  Per the WSJ, "On April 1, Japan’s Financial Services Agency put in place new rules for bitcoin, which recognized it as a legitimate payment method. Japan quickly became one of the largest markets for bitcoin, currently representing about 60% of all trading."

And that brings me back to the biggest cryptocurrency business.  Not an application or a new technology but investing, trading, and speculating on price action.  Speculation is such an integral part of Bitcoin that new jargon emerged to describe the psychology of owning it: 1) FOMO (Fear Of Missing Out) and 2) HODL (Holding On For Dear Life).  Bitcoin was engineered to be bubbly.

Bubble Psychology

While writing that first newsletter in 2013 I understood that bitcoin is perfectly engineered to bubble.  We've written on bubbles previously in our book "Trading on Sentiment:  The Power of Minds Over Markets" (Wiley, 2016) which has two chapters on bubbles, and also in this past newsletter.

According to the staging system we propose, we're solidly in late Stage 2/early Stage 3 with cryptocurrencies - we've entered a full on bubble.  Yet while exchanges seem to freeze when people are rushing in or out of bitcoin, ironically bitcoin's slow clearing speed may prevent short term panic.  And not many new investors have enough money at stake to be scared of the risks yet.  Bubbles often implode when people "look down" and realize they are vulnerable.  But for now many investors are still trying to rush into bitcoin while reading success stories like those of my friend.  

Positive feedback loops drive attention and hoarding of popular cryptocurrencies.  Speaking of blockchain start-ups, VC Josh Nussbaum notes: "[B]y aligning incentives between all stakeholders, networks can grow faster, providing just the type of positive feedback loop that can unseat centralized incumbents with their treasure trove of data and cash."  If you're considering investing in cryptocurrencies, be sure to identify those with positive feedback loops between token scarcity, users' need to buy tokens to participate, subsequent price appreciation, and widening attention.  

What are the odds that bitcoin will double versus drop 90% over the next five years?  Better than 50/50?  Given that it has risen 5000-fold since I first investigated it, I'd say the odds are in favor of doubling.  Yes, there is a media frenzy.  Yes, it will hit short-term speculative tops (a "blow-off tops") as it has done several times in the past and dropped 80-90% subsequently.  I realize that past history is not a predictor of future returns.  And I understand that bitcoin has no fundamental value.  Yet bitcoin was designed to create a perfect psychology-driven asset bubble.  And even with government bans, crackdowns, trading freezes, etc..., the cryptocurrency frenzy has only grown through today.

The Psychological Predictors of Currency Performance

Helping bitcoin and other cryptocurrencies along is the public belief - and the news and social media forecasts - that they could go higher. 

James Mackintosh of the WSJ noted,  "[F]or the moment, bitcoin’s best hope looks like attracting more and more buyers who want to shift their savings onto the blockchain—and speculators willing to bet that those savers will arrive. The soaring price of bitcoin alone shows that expectations are high. But as currency historian and Berkeley economics professor Barry Eichengreen said: “Expectations can change.""  Adding his voice, Nobel laureate Joseph Stiglitz noted, "The value of a bitcoin today is expectations of what the bitcoin is going to be tomorrow."  Both are right - expectations explain why bitcoin can go higher (or lower).

At MarketPsych Data, we use text analysis software to quantify references to sentiments, themes, and tones expressed about trade-able assets from thousands of social and news media sources in real-time.  We sell this data through Thomson Reuters to banks, funds, brokerages, consultancies, and governments as the Thomson Reuters MarketPsych Indices (TRMI).  

Performing quantitative testing on our currency sentiment data, our Head of Research CJ Liu examined how national currencies performed since 1998 on weekly, monthly, and yearly rotational models when various media themes or sentiments were predominant.  His software first selected the 20 currencies with the most mentions in the media over a prior period.  It then ranked them by their average "Price Forecast" over that period (the priceForecast TMRI).  It then created a portfolio by going long the top quartile (top 5) of currencies with the highest priceForecast score and going short the bottom 5 with the lowest priceForecast score.  He plotted the return of $1 invested in this strategy, with $0.10 allocated to each currency at the beginning of each rolling period.

From CJ's research it appears that currency prices go where the media predicts they will go:

We can see this effect broadly in the U.S. Dollar, using this screenshot from our online sentiment research charts:

Using a daily model we see a variety of sentiments that predict next day returns.  High one-day values on TRMI called priceDirection, volatility, optimism, and longShort (references to buying minus selling) all seems to predict higher next-day returns.

Such indexes can be combined into more comprehensive models.  Unfortunately we haven't done specific quantitative modeling for Bitcoin yet.  However we do sell Bitcoin sentiment TRMIs at 60-second, hourly, and daily granularity to quants via our currencies sentiment package.  And we are able to chart recent Bitcoin sentiment to look for patterns.

Cryptocurrency Sentiment

Using our bitcoin sentiment feed, we charted monthly sentiment about Bitcoin in news and social media from 2010 to 2017 below.  The overall sentiment in the first two days of December is at an all-time high, but two days is unrepresentative.  More interesting is that the total monthly November 2017 sentiment for bitcoin was at the high of the range, but not beyond.  In general, bitcoin sentiment does not look excessively high.

But since sentiment isn't a clear predictor of currency prices in most cases, we'll look at PriceForecast next.  

The chart below covers only 2017.  While the PriceDirection index rose in 2017 (the blue line), which was consistent with the price rising this year, the PriceForecast index actually sagged.  Commentators are becoming more negative on bitcoin's price prospects while the price rises.  Importantly, for traditional currencies the overall price forecast is a more significant long term predictor than other sentiments.

We've developed cryptocurrency sentiment feeds covering the top 100 cryptocurrencies.  Stay tuned for launch information on those.

Into the Ether

You don't have to be right often in life to significantly change your fortunes.  Being extremely right once or twice - who you marry, what you choose to study, or whether you buy into a new technology early on - can benefit your life 1,000 or 10,000 times in any given dimension.

Only risk capital - money you wouldn't mind doing without - should be used in speculation in cryptocurrency. Also keep in mind that criminals thrive in the relative anonymity of the bitcoin world.  Malfeasance and insecurity is common.  Tip to the noobs (amateur cryptocurrency investors):  Be prudent and take security very, very seriously.  Most coins are scams.  Some have back doors into their code, are premined (in which the issuers take lots of coins for themselves), or are simply created as pump-and-dump schemes.  A list of some scams here.

Revolutionary new technology is being created in the blockchain and smart contract space.  Yet there are many considerations that need to be navigated.  Adoption of this technology, like with the internet, is going to be much slower than we want to believe.  As such, the short term may be a positive and wild ride, but longer term prices will likely end up much lower than they are now for bitcoin.  There is already a good deal of smart money chasing deals.  There is competition emerging - new cryptocurrency technologies will be emerging from the large tech companies like Google and Baidu, and they will have immediate scale.  Without acceptance of cryptocurrencies as actual fiat currency by governments, then the regulatory environment will be prohibitive to their common use. There is a lot to consider, and blindly speculating on these is not a good idea - belief that allows one to weather the volatility is based on understanding.

Our Thomson Reuters MarketPsych Indices are deployed globally to monitor real-time market psychology and macroeconomic trends.  If you're an academic interested in data for research, please reach out for access.  If you represent an institution, please contact us.  The commercial Thomson Reuters MarketPsych Indices dataset covers 45 currencies (including Bitcoin), 62 countries' fixed income products and stock indexes, 12,000+ companies and stocks, 36 commodities, and 187 countries.  

Happy Investing!
Richard Peterson and the MarketPsych Team

EDITOR'S NOTE

This is a Hedgeye Guest Contributor piece written by Dr. Richard Peterson. Peterson is CEO of the MarketPsych group of companies where he leads MarketPsych's data and asset management division. He has trained thousands of professionals globally to leverage behavioral insights. He is a board-certified psychiatrist and author of Trading on Sentiment.This piece does not necessarily reflect the opinion of Hedgeye.