Bitcoin – boom or bubble?

At times it feels like everyone is talking about bitcoin, whether it’s the bloke down the pub saying he might try and invest or the institutional investors scoffing at those foolish to invest their money in a digital currency. I’ve had countless emails from the general public and journalists asking what I think about bitcoin and whether they should invest. So this article is a response to that demand. I explain what exactly bitcoin is and discuss whether it is in a bubble or not.

What is bitcoin

Bitcoin is the most well known digital currency, also known as a cryptocurrency. It was created by a computer programmer called Satoshi Nakamoto in 2008. However, for reasons only known to Nakamoto he decided to disappear into obscurity in a similar fashion to Lord Lucan, but without the scandal, and there have been numerous sightings and failed searches to identify him ever since. From such obscure beginnings bitcoin's growth has been driven by online advocates attracted by its anonymity and usefulness as a decentralised currency. Decentralised means that no government has control over it and it operates outside of the mainstream banking system. While it can operate like a currency it does have some fundamental differences. For example there is (and will) only ever be a finite number of bitcoins in existence and new bitcoins can be mined using computer programmes. Bitcoin transactions are recorded via blockchain, which is a form of online ledger. This blockchain makes it far more effective to move assets (including bitcoin) across the internet and as such has attracted a lot of attention from technology and financial institutions. In the future the blockchain could be used as an online ledger for all sorts of financial transactions including share dealing.

However, some of bitcoin’s deliberate design features have also limited its mainstream uptake. For example, the very fact that it’s decentralised has drawn criticism from governments. In addition, the lack of regulation makes cryptocurrenices vulnerable to fraud and money laundering. As bitcoin transactions are irreversible if there is a fraudulent transaction then the user is unlikely to ever see their money again. More concerning is the fact that as it is an online entity this leaves it vulnerable to hackers. Mt. Gox was a bitcoin exchange in Tokyo that by 2014 was handling 70% of the world’s bitcoin transactions. Yet in that same year the exchange filed for bankruptcy after 850,000 bitcoins valued at $450million belonging to customers went missing presumably through hacking.

Putting these concerns to one side, the meteoric rise of bitcoin hasn’t passed the mainstream media by. On the 30th May 2016 the price of bitcoin was $550. Today it is now worth over $6,000 which is almost a 1000% increase in 18 months. So in the pursuit of balance below I look at why bitcoin is in a bubble and then conversely explore why it might not be.

Why bitcoin could be in a bubble

Investment bubbles are interesting beasts which usually develop in a similar way even though the underlying asset may be as different as tulips and bitcoin. Below is the most widely accepted analogy of an investment bubble (click to enlarge).

You will see that there are distinct stages of an investment bubble from the stealth phase right the way to mania where everyone from your hairdresser or ‘the bloke down the pub’ is talking about investing in the asset. So the question is where is bitcoin on this roadmap? Interestingly the FT published a chart overlaying the historic price of bitcoin over the top of the above bubble chart and the result is alarming.

However we need to be careful when rushing to conclusions. Firstly the peaks and troughs of the ‘bubble analogy chart’ are not to any form of scale. What is important is that the peaks and troughs are relative to one another, which is particularly noticeable around the ‘bull trap’ area which resides in the ‘blow off phase’. You will notice that the ‘return to normal’ peak is below the ‘new paradigm’ high. The fact that bitcoin would appear to be following the textbook bubble trajectory should set alarm bells ringing.

However, that chart was published a month ago and since then bitcoin has propelled to new record highs above $6.000 per bitcoin, as shown in the chart below.

The trouble is that real-life doesn’t follow the text books so trying to force it to can lead to inaccurate conclusions. The latest leg up in the price of bitcoin doesn’t fit nicely into the bubble analogy chart. If you were to redraw the bubble chart overlay again, taking the latest price rise into account, would the current new high be the equivalent of the ‘new paradigm’? It would probably have to be if you wanted to maintain your bubble thesis. The reality is that the analogy chart shouldn’t be taken literally and is better used as a pictorial representation of a fairly complex idea. However, what the exercise does highlight is that you only really know where you are in a bubble’s formation with the benefit of hindsight.

Maybe the bubble isn’t about to pop just yet

The above exercise does raise another interesting observation, which is that institutions have largely avoided bitcoin. Typically institutions are the first to fuel a bubble while the general public are the last to join the fray and are left nursing their greater losses. At present bitcoin hasn’t become a mainstream investment asset nor is it bought widely by the public. Part of that stems from how cumbersome it is to invest in cryptocurrencies although Hargreaves Lansdown now offers a bitcoin ETF tracker fund called XBT Provider AB Bitcoin Tracker One. However, like all things bitcoin it's never simple. Firstly it doesn't exactly track the bitcoin price but is 'strongly influenced' by it. Plus you can only invest in it via HL's SIPP or Share and Fund account plus it is denominated in Swedish Krona (as XBT are based in Sweden). That means that on top of the volatility of bitcoin you are also exposed to currency moves between the krona and the US dollar. It's only when we see true bitcoin ETFs in the US and more widely available in other markets will bitcoin go mainstream and speculation leap to another level.

At present it’s only a relatively small niche of private speculators and money launderers who are responsible for the 1,000% price increase over the last 12 months while institutions have mostly given bitcoin a wide berth. Indeed JP Morgan chief executive Jamie Dimon recently dismissed the currency as a fraud. But some institutions are starting to take note, for example Goldman Sachs is considering opening a bitcoin exchange.

There are some analysts that believe that some governments, which have so far either shunned or outright banned bitcoin's use (such as in China), may soon officially recognise bitcoin. For example, Japan looks set to attempt to regulate and encourage bitcoin use. Indeed this week's $6,000 price record was the result of speculation that China could be about to lift its ban on the cryptocurrency. It’s lead some to claim that bitcoin is currently at a similar stage as the tech bubble in 1994 and has plenty of room to grow. The tech bubble eventually popped some six years later. However, the chart below shows that we are probably past ‘1994’ territory already

One of the misconceptions of bitcoin is that the price has gone straight upwards when in fact we’ve seen some big sell-offs and rallies. Let’s be clear that bitcoin is incredibly volatile and as such those who enter it in the hope catching an upswing are speculating and not investing. Yet the wild price swings in bitcoin are interesting. You will be familiar with my previous technical analysis articles in which I show lines of resistance and support to identify potential future price moves. There are many variations of technical analysis that can be used to identify these lines of support and resistance and using Fibonacci analysis is one of them. If you remember from school Fibonacci numbers were those crazy numbers that started 0, 1, 1, 2, 3, 5, 8, 13, 21, 34,…. where each number in the sequence is the sum of the previous two numbers. This sequence has some interesting properties including some interesting ratios (one being the Golden ratio). These can be used to predict the scale of any market uptrend or fall. Using these ratios you can also predict support and resistance lines for a market, irrespective of the asset.

Interestingly, since 2013 the rapid rallies and crashes of the price of bitcoin have followed these lines of support and resistance identified by the golden ratio. Some Fibonacci analysts claim that makes $4,700 a critical floor which the price of bitcoin mustn’t fall through if the current uptrend is to go higher. If it does then expect targets of $6,500 and possibly $7,400 (note: at the time of writing both were a long way off yet the first target has since fallen).

The problem is that these predictions are based on a market operating in a fairly normal time constraint of possibly months and years. In the world of bitcoin these resistance and support levels could all be tested/attained or broken incredibly quickly. Some would argue that this volatility is a mark of how highly illiquid bitcoin is. Others would run for the hills as it makes timing when to get in and out extremely difficult. Ordinarily it’s inadvisable to attempt to market time when investing but most people currently buying into bitcoin are speculating/gambling so market timing and a bit of luck is their biggest hope.

What will happen if/when the bubble bursts?

Whether you believe bitcoin is in a bubble or not. The cryptocurrency’s meteoric rise isn’t sustainable indefinitely but predicting when we will see the end is akin to predicting when equity markets will roll over. Advocates of bitcoin and other cryptocurrencies claim that the world hasn’t yet woken up to the potential of bitcoin and once governments and institutions accept the inevitability of bitcoin and its peers bitcoin can continue its uptrend. However, while cryptocurrencies may not yet be mainstream the technology that they are based upon (such as blockchain) is becoming increasingly commercial with financial and technology firms investing in its development. Investing in these companies is one way to get indirect exposure to bitcoin. However, there are also a number of firms that have indirectly benefited from cryptocurrency’s rise, such as computer chip firms seeing an increase in demand from ‘bitcoin miners’. Perhaps more worrying is the rise of tech start-ups using their cryptocurrencies to raise funding. By creating their own cryptocurrency they can use it to raise funds in what is called an initial coin offering or ICO. These so-called ICOs are unregulated and avoid the regulation involved in a normal IPO. What could possibly go wrong? The sector is rife with fraudulent trading and marketing practices and the more money that is sucked in the greater the dangers become. The problem is if there is a large scale sell-off in a cryptocurrency then there’s a greater chance of a knock on effect into the mainstream technology and finance sectors.

Summary

Bitcoin's price can and will likely continue to rise, in the short term anyway, hence why I included those price targets. But the pace of that rise is unsustainable and is reminiscent of a bubble that looks prone to bursting. While the market is showing the hallmarks of a bubble most bitcoin advocates dismiss this by claiming the currency has yet to go mainstream and when it does the price will really take off. Yet there are a number of hurdles hindering that. For one, bitcoin's volatility makes it almost useless as a currency as it's value changes wildly from day to day. In addition it is unregulated, a hunting ground for fraudsters and incredibly vulnerable to disruptive government policy. Furthermore Bitcoin has also undergone a number of splits which have given rise to other variants, namely bitcoin cash and bitcoin gold. These splits or ‘hard forks’ are attempts to overcome some of the frustrations in the way bitcoin was designed, for example the finite number of bitcoins and how difficult they are to mine. The splits are caused by crypto-community advocates which does undermine bitcoin’s right of passage as a mainstream currency. There's no doubting that bitcoin has made people millionaires but how much of that is down to smart investing and how much is down to luck is debatable.

The other point to make is that assuming that you accept bitcoin as a currency then it's important to remember that ordinary currency investing is a high risk investment strategy, but bitcoin is even riskier. To move a major currency by 20% in a day would take a major world event and is almost unheard of. In the world of bitcoin we’ve seen its value drop 20% in a single day or less. To sum up, perhaps the greatest danger of investing in bitcoin is not simply the wild price moves but lack of regulation and controls. While I won't invest in bitcoin it's not for me to judge others that do, I just hope they go into it with their eyes open and the realisation that they could lose everything and are essentially speculating on a market driven purely by greed at the moment.