“One of the saddest lessons of history is this: If we’ve been bamboozled long enough, we tend to reject any evidence of the bamboozle. We’re no longer interested in finding out the truth. The bamboozle has captured us. It’s simply too painful to acknowledge, even to ourselves, that we’ve been taken. Once you give a charlatan power over you, you almost never get it back.”
- Carl Sagan
In the process of roughing out a new “Strategy” piece I found myself veering off on one of my coffee-inspired rants that threatened to turn another brief write-up into a dissertation. Rather than delete or edit the rant, I’ve chosen to split it out for its own dissertation. You’re welcome.
I’ve been getting some questions about Bitcoin. I think it’s a fascinating topic given the current, collective manic investment mood. I’m not proud to admit that I did buy a few
Bitcoins at an average cost of about $700 and subsequently sold them at just over $2,300. I know what you’re thinking…why didn’t I buy any for you!? Simma down. For starters, there hasn’t been a mechanism to buy these things through a brokerage account. Far more importantly, I didn’t think it wise for an investment adviser to invest client money in Beanie Babies, and it wasn’t at all clear to me that Bitcoin was anything more than an updated digital Beanie incarnation, and a far less cuddly version at that.
I don’t remember exactly when I first heard of Bitcoins, but I’m sure my curiosity was piqued by the fact that they’re always depicted as being a gold coin. It didn’t take much digging to realize that Bitcoin has absolutely nothing to do with gold. Still, I find it interesting that the earliest Bitcoin marketers chose to associate a digital coin backed by nothing with a tangible precious metal which has stood the test of time as money. So, I didn't buy some Bitcoins because of any link to gold. I bought a few coins personally because, at first pass, I saw that they had some potentially bubble-inducing characteristics – limited supply, no anchor to anything tangible, privacy, decentralization and an unquantifiable strange sexiness…kind of like Lady Gaga and Adrien Brody possess. More importantly, I bought a Bit of Coins because I knew that doing so would force me to spend some time understanding what they were about, especially since there’s a good chance that the technology behind Bitcoin could impact just about every industry in the future. Mission accomplished.
I’m not going to bore you with too many details about how Bitcoins are created or how they work. If you really want to learn about the mechanics behind it…well, that’s what Google is for. The more interesting question to me is whether these “coins” are a legitimate investment opportunity or simply the latest mania bound to fleece a gullible public. I fear the title may have killed any suspense. Still, let’s consider some evidence…
Making Headlines
My experience has been that it’s not typically a good time to buy an asset when people start asking me about it AFTER an explosive move higher and lots of press attention. When Ma and Pa Retail (that’s you) start buying into the hype of an asset class it’s usually pretty late in the game. Who do you think the early “pioneers” are going to sell to?
Worse still is when people with no investment background start believing they’re the latest Warren Buffett due to a lucky trade or two and then start telling me what I should buy. This is exactly what happened during the Dot.Com frenzy and the real estate bubble. Piano teachers, veterinarians and plumbers suddenly became investment experts. It’s no different today. We have thousands of newly-minted experts on Bitcoin and cryptocurrencies, many of them too young to remember the Dot.Com bubble and collapse. They may lack the qualifications to wait tables or dog sit, but they’re confident and hip enough to preach the gospel of cryptocurrencies with the confidence and self-righteousness that only a millennial could muster from Mom’s guest room after a grueling 3-hour shift at Starbucks. Time will tell if they’re actually new investment gurus or just pre-blow-up bubble-riders. Actually, there’s no need to wait. I’ll tell you. 99% of them will end up investment roadkill.
Excellent investment opportunities don’t rely on hype, optics or aggressive marketing. It’s usually the exact opposite. The best long-term investment opportunities typically fly under the radar, are out of favor and are very inexpensive. The hyperbole phase comes toward the peak of the bubble as the smart/lucky early investors are looking to unload their investment on suckers chumps new investors. Here’s a sampling of some of the more interesting recent cryptocurrency headlines I’ve seen:
“Iced Tea Firm’s Shares Quadruple After Changing Name to ‘Long Blockchain Corporation’”
“Cigar Business Ditches Cigars For Bitcoin”
“A Cryptocurrency Created As A Parody Is Now Worth More Than $1 Billion”
“A Biotech Company Changed Its Name to ‘Riot Blockchain’ and Its Stock Is Surging”
“This Dominatrix Makes Men Mine Cryptocurrency For Her – And She Now Has Over $1 Million”
“People Are Mortgaging Their Houses to Buy Bitcoin”
“Forsooth! Was Bitcoin Foreseen By Nostradamus?”
“Researchers Find That One Person Likely Drove Bitcoin From $150 to $1,000”
“97% Of All Bitcoins Are Held By 4% Of Addresses”
“This Man Has Made More Money Trading Cryptokitties Than Investing In His IRA”
“Poll: Some Investors Use a Credit Card to Buy Bitcoin and Then Carry Over the Balance”
“Venezuela Plans Its Own Version of Bitcoin as Debt Crisis Worsens”
“Hooters Franchisee Surges 41% on Cryptocurrency Rewards Program”
“Kodak’s Stock Doubles After Camera and Film Pioneer Boards Blockchain Bandwagon”
These are not the type of stories you see at the bottom. Companies are seeing big surges in their stocks after simply changing their name to incorporate the words “Bitcoin” or “Blockchain” (more info on blockchain a bit later) or by announcing some tenuous connection to blockchain technology. Sound familiar? We saw the exact same thing during the Dot.Com bubble when companies were rewarded with big stock price pops by simply adding “.com” to their company name. Almost all of those companies ultimately plummeted in value and most ultimately failed. I have no doubt that today’s crop will suffer the same fate. The value of these companies didn’t magically expand dramatically. Investors simply bid these shares up because they thought other investors would bid the shares up. It becomes self-fulfilling, but it’s based on hot air and ALWAYS deflates. This time will be no different. I mean…Hooters? Kodak? C’mon.
Early Appeal
In the beginning…there was Bitcoin. It was the only digital coin, and it came with the promise that only 21 million Bitcoins could ever be mined. Unlike with dollars or other fiat currencies, there was a promised limited supply of these digital coins. This was one of the primary factors that sparked my initial interest. We all know that there is no limit to the number of fiat dollars that can be produced, so a currency that guaranteed a limit to its supply sounded intriguing…even gold-like.
However, differences within the Bitcoin community have resulted in “forks” – a change to the underlying software of Bitcoin that creates two separate versions of the blockchain with a shared history. With each fork a new Bitcoin (with a different name) is created for each Bitcoin that exists. A fork in August of last year led to the creation of Bitcoin Cash while another fork in October created Bitcoin Gold. Now there’s a Bitcoin Private fork scheduled to occur any day now. In just a few months the total number of “Bitcoins” will have essentially quadrupled. There’s no limit to how many future forks there may be.
Far more damaging to the scarcity argument is the sheer explosion in the number of alternative digital coins which have followed in the footsteps of Bitcoin. You may have heard of some of these – Ethereum, Ripple, Litecoin, etc. At last count, there were about 1,500 different cryptocurrencies in existence with new ones coming out each day. Don’t be fooled. There is nothing sophisticated or challenging about creating a new coin. Some mediocre developers could easily create a new one in a day. The hard part is generating attention for your new coin. The trick with most coins is in the marketing, not the technology. The scarcity argument that was so compelling in the early days of Bitcoin has been obliterated.
Fraud and Regulation
Whenever a lot of money is being made quickly in some investment area, you can be sure that the crooks are paying attention. Considering just how novel, complicated, virtual, unregulated, volatile and rapidly evolving the crypto space is it must be like Disneyland for fraudsters, thieves and charlatans…and it is.
Here’s just a sampling of the thievery that has occurred so far:
Mt. Gox was a Bitcoin exchange that was handling about 70% of all Bitcoin transactions in 2014. In February of that year it filed for bankruptcy after reporting that 850,000 Bitcoins were stolen from customer accounts, an amount equal to $460 million at the time.
Etherium ended up forking last year after a coding flaw resulted in $79 million being stolen by a hacker.
Slovenian-based Bitcoin marketplace, NiceHash, had $64 million in Bitcoin stolen last December.
Ernst & Young has estimated that $400 million raised through various Initial Coin Offerings has been “lost” or stolen.
Bitconnect, a lending and exchange platform, was promising guaranteed returns of up to 120% PER YEAR. All you had to do was deposit your Bitcoin with them, buy their Bitconnect coin and then lend out your Bitconnect coin on their exchange. Bitconnect shut its exchange last week after receiving cease and desist letters from U.S. securities regulators. Their cryptocurrency once traded over $400. It sits at $15 today…still about $15 too high.
Bitfinex, one of the largest digital currency exchanges, reported in 2016 that $66 million in Bitcoin was stolen from customer accounts.
Tether reported that $30 million of its cryptocurrency was stolen last November by hackers.
One of the appealing aspects of cryptocurrencies was that they operated outside of any regulatory framework. You could circumvent the dollar, the Fed, the banking industry, the government and all of the government’s regulations by choosing Bitcoin and its ilk. Well, the regulators are coming. The regulators have had to get up to speed themselves, but they’re coming. With each fraud that is exposed more negative attention is being drawn to this space and more people are clamoring for some protection and oversight. Even many of the original proponents of these coins who once touted the benefits of no government involvement are now claiming that regulation is needed. Conveniently, they also claim that more oversight will, of course, be bullish for the coins.
Comparison to Prior Bubbles
One way to judge if an asset is currently in a bubble is to compare its price action to known historical bubbles. The chart below does just that. It shows how Bitcoin’s gain over the past two years compares to some of the largest two-year moves in history. The line for Bitcoin is at the top and exceeds the two-year gains experienced during the Mississippi Company bubble, the Beanie Baby craze, the Dot.com insanity and the cornering of the silver market by the Hunt brothers.
Even though Bitcoin is clearly in a bubble, we won’t know for sure if we’ve seen the peak until well after the fact. In the meantime, there are plenty of vocal and confident Bitcoin disciples eager to preach the gospel of ever higher prices. One of my favorites is the always-colorful John McAfee, founder of McAfee Antivirus. John exudes an incredible amount of confidence, going so far as to tweet on November 29th of last year, “I now predict Bitcoin at $1 million by the end of 2020. I will still eat my d*ck if wrong.” And, no, he doesn’t own a duck. John’s an interesting guy with a colorful past, but he’s talking his book. It has recently come to light that John will happily tout your digital coin for the tidy little fee of 15 Bitcoins, so I think it fair to question his objectivity.
Does John really believe Bitcoin will go to $1 million? Only he knows. As I see it, if he predicts Bitcoin will go to $100,000, many people would scoff and not take him seriously. BUT, if he predicts it’ll go to $1 million, then people will scoff and say that’s outlandish…but it makes $100,000 seem less crazy, and if you think it could go to just $100,000 then you’d better hurry up and buy! It’s easier to sucker more people in with otherworldly, ridiculous predictions, especially when the public is primed for a frenzy. Again, this all sounds quite a bit like the Dot.Com bubble when new valuation metrics were created in order to justify insane market values and outlandish returns. Remember how everyone was going to be a millionaire?
The Coin Is Not The Technology!
Perhaps the biggest source of confusion with the digital coin mania is the distinction between the coin itself and the technology behind it. The technology is known as blockchain or distributed ledger technology (DLT), although technically blockchain is a form of DLT. I’m oversimplifying, but the beauty of DLT is that it eliminates the need for a central point of control because the data is securely spread across a computer network. The technology of blockchain is certainly fascinating and holds much promise, but we’ve yet to see any grand applications in the 10 years since its creation. It seems as though many potential uses were floated without really understanding how current systems work. By way of example, it has been suggested that Bitcoin and blockchain technology would supplant payment processing networks, but the current Visa network can handle about 60,000 transactions per second. Bitcoin? It can handle 7 per second and takes 35 times as much energy. The blockchain technology has some serious flaws, including scalability.
I’m not sure many people realize just how inefficient Bitcoin’s blockchain is. It relies on “miners” who get rewarded for making the network secure in the form of newly minted Bitcoins. This is much more of a flaw than a necessity as all miners are in competition for that next Bitcoin. It results in a huge network-wide competition to waste electricity, with the miner who wastes more electricity and computing capacity the quickest getting the new Bitcoin. The idea is to keep the bad guys at bay by making the whole process so energy and computer-intensive that no bad guys could ever acquire enough computing capacity to out-vote (or out-waste) the rest of the network. It is designed to be wasteful and slow. It’s estimated that the global Bitcoin network already consumes more electricity than some small countries. How can this possibly be practical or viable for any large-scale use?
Here’s a secret. Bitcoin is not special. It is not unique. It was just first. Blockchain is a fascinating new technology, but it’s simply a prototype that proves that the concept of DLP can work. Bitcoin will always have some value but only as a collector’s item because it was first.
Inevitably, we will see the development of new DLT that doesn’t require miner competition and the incredible inefficiencies and waste that accompany it. There are many alternatives currently being developed, like HashGraph, which don’t rely on miners or integration with a cryptocurrency. The market will ultimately determine the winners, but it won’t be Bitcoin or the current iteration of blockchain technology. This is an important point. DLT does not have to rely on miners, be slow and wasteful, or be associated with a cryptocurrency.
Conclusion
I’ve made no secret of the fact that I believe many stock and bond markets are well into bubble territory, but this crypto space is something special. At least when I buy a stock I have a part ownership of a business and a claim on future free cash flows. With a corporate bond, I’m entitled to interest payments and a claim on the assets of the firm in the event of failure. With the Beanie Baby craze, buyers at least had a tangible toy they could admire or let their dog gnaw on. If you bought a tulip bulb during the Dutch tulip bulb mania you at least owned an actual bulb that you could plant.
What do you own when you buy a cryptocurrency? The blockchain technology is free to anyone. You don’t own that. You’re basically just getting a free electronic ledger with transactions listed on it. What is the value of that? Well, the intrinsic value of that is very clearly zero. $0. Nothing. The market value, however, is whatever the marginal buyer is willing to pay for it, as is the case with any asset. Bitcoin will likely always have some value simply because it was first. Even if blockchain technology has little practical ultimate value, Bitcoin is likely to have some value as a collectible. As for the others…I feel quite confident that the overwhelming majority of the cryptocurrencies in existence today will trend toward their intrinsic value. How much can an easily replicable virtual coin backed by nothing and offering no claim on the soon-to-be-outdated technology underlying it really be worth?
As with any bubble, it is the Fear Of Missing Out (FOMO) that is driving prices higher. Small, uninformed investors are busy jumping on the bandwagon and falling for the con of the swindlers and insiders and dreaming that they too will soon be able to buy a Lamborghini like the 17-year old Bitcoin millionaire they read about. History tells us time and again how these stories end.
That’s not to say that cryptocurrencies will disappear altogether. I believe that they’re here to stay, but I also believe that it will be government-backed digital coins that will be the ultimate “winners”. No government is going to allow a successful private currency to compete with their national fiat currency. Governments will increasingly point to fraud, tax evasion and terrorism as reasons they need to outlaw cryptocurrencies. They’ll get rid of the legitimate competition and issue their own digital money which will circumvent most of the original objectives behind the creation of Bitcoin. A government-sponsored coin will be easily traceable, confiscatable and taxable. Legal tender has always been the domain of governments, and it would be incredibly naïve to think that the advent of Bitcoin has changed this in any way.
Lost in the frenzy for Bitcoin and the other digital coins is the fact that Distributed Ledger Technology is truly fascinating with seemingly unlimited potential uses. Blockchain is simply the first iteration, but a critically important one in that it proved that DLT actually works in the real world. Still, its shortcomings are deal breakers when it comes to most practical applications. As with any other software DLT will evolve, and I imagine it will evolve very quickly. New forms of DLT will be released that overcome the pitfalls of blockchain and that don’t require a currency component at all. These will be the DLT platforms that businesses ultimately adopt.
I decided to spend some time on this topic for a few reasons. First, I was getting more questions about it and whether I thought the crypto space was a bubble. Second, I do think there will be some incredible developments in this area but more so on the technology side than on the currency side (where government will dominate the tapestry in the future). We may make some investments in the crypto space at some point, but they’ll most likely be on the technology side and not in digital coins themselves. Finally, most big bubbles go through a final blow-off, mania phase before peaking. The U.S. stock market is at nose bleed levels with many bond markets also in bubble territory. The mania surrounding Bitcoin and its brethren is just the cherry on top of this global asset bubble. I’ve always been careful not to predict when a bubble will end, but I will say that all of the signs of an impending top are present. The days of the digital coin mania and stock market mania are numbered. I ultimately expect losses in excess of 90% for most digital coins and 50%+ for the stock market. So, as compelling as it looks, I'm going to take a hard pass on Banana Coin.
Best,
Ken Bell, CFA, CFP, MBA, Comfortable Current NoCoiner
1/27/18
The Market Rubbernecker is associated with Aspera Financial, LLC, an investment management and financial planning firm based in the Cary, Raleigh, and Durham area of North Carolina. This and all Market Rubbernecker missives and musings (written, oral, or mimed) are subject to the disclaimers, disavowals, and hindquarter-coverings found at www.asperafinancial.com/aboutrubbernecker.