Could Bitcoin Really be a Bubble? The Pros and Cons
In February 2018, during the spectacular fall in price from the 2017 peak, Nouriel Roubini, an esteemed economist, in more conventional circles, called Bitcoin ‘the biggest bubble in human history’. He certainly got something right - never before has history seen such a phenomenally exponential rise in an asset. And then, at the bottom of the crash near a year later, Roubini saw Bitcoin as bust for good.
Nouriel Roubini @Nouriel
November 20th 2018
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What is surprising here, coming from a macro-economist, is his use of nominal values [percentages off the peak price]. If he’d used real values instead [something I’ll touch on here, and look into more fully in a future article], he may have thought twice before declaring Bitcoin ‘bust for good’. With price now recovered back to the levels of the previous peak, it’s perhaps timely to revisit this idea of Bitcoin as a bubble. In looking at the pros and cons of it, my aim will be to finally put this idea to bed…. and not from the perspective of a [hyper] inflationist, who sees everything in a bubble [bubble-everything] due to fiat losing value, but from the perspective of the pragmatic and hedged investor, who’s unable to afford the luxury of such fundamental ‘certainties’.
As we all know, financial history is littered with examples of speculative manias and bubbles. No doubt bubbles can take various forms, but this article will focus on those relatively shorter-term speculative manias that can last anywhere between a few years to a decade. Most of us have heard of the bubble in Tulips, the Mississippi bubble, the South Seas bubble, and then the manias closer to our time that developed in land, in real estate, and of course in stock markets. The recurrent pattern is one of boom and bust, a pattern itself made possible by the creation of vast amounts of credit/ debt - a rapid inflation of financial value followed by a subsequent and calamitous deflation in value - the bubbles no longer become sustainable [the go-to book on this all too human folly is J. K. Galbraith’s ‘A Short History of Speculative Manias’]. Given the history, the obvious question today facing us is whether Bitcoin itself could be a bubble. I’ll give my own response to this question by looking at the pros and cons. The aim will be to look the proposition squarely in the face, as any rational investor is bound to do, and then sketch out a reasonable position that investors could [or should] have toward that phenomenon we call Bitcoin.
First of, the returns in Bitcoin, which have been absolutely phenomenal compared to more traditional assets, is bound to alarm the more conventional investor. How, he asks, can this not be a bubble. It is no help to him that Bitcoin enthusiasts seek to go out of their way to explain the fundamentals to him, as this only reinforces his perception of a bubble - bubbles involve mania, and nowhere does he see a mania more clearly than in those who are explaining the cast iron laws as to why Bitcoin must move inexorably to ever more exponential heights. There is no help to be found here - the perfectly good intentions of the Bitcoin fundamentalist may actually serve as a hindrance in this case. Besides the FA though there is TA, and given the border-line mania that exists, it is to TA that those averse to manias must turn. And yet investors, used to more conventional markets, struggle to make sense of what seems at first sight an incomprehensible chart. Price explodes straight up, and then collapses, and then explodes straight up again.
Somewhat similar to this Bitcoin chart, and also in the linear scale, is the chart of the Tulip bubble, where once again price rises exponentially only to collapse again.
Here we see a speculative frenzy culminating in 200x over a few months before the collapse. Unlike Bitcoin however, is the shorter duration - Bitcoin has currently been on its upward march for a full decade now, which is of quite some duration compared to other careers in bubbles.
The next chart maps many of the most famous bubbles, both historic and recent. Once again on the linear scale. This scale manages to map Bitcoin up to 2014 [the later 2017 rise would have price well and truly off the chart, and eclipsing the Tulip mania]. What you start to see here is how different Bitcoin is to previous bubbles - either it’s a different kind of bubble, or simply of a different kind altogether… or both [why be stuck with either/ or].
When also factoring in the 2017 rise in Bitcoin [now 1700x as comparable to the 35x], the above chart depicts Bitcoin on something of a quite different scale altogether. And so, unsurprisingly, we’re compelled to shift to the logarithmic scale to compare these various phenomena of the financial world in order to make some sense of them. The problem here are the exponential moves in Bitcoin [to both sides] that the linear scale is simply incapable of charting/ measuring. As mentioned, many investors are used to conventional markets that move, in comparative terms, at a snail’s pace, and so for those kind of markets, the linear scale if fine. Not so for Bitcoin.
On the logarithmic scale, one is enabled to have a closer look at how the price of bitcoin is actually developing even though at often exponential rates. And in looking at the chart, you can see that price is not, contrary to the headlines, moving randomly, but has rather some stops and starts in a somewhat more regular manner. There seems to be a pattern - a series of exponential rises and exponential corrections.
Here is an interesting chart by Blockchain Capital, who have plotted the bubbles as relative to one another on the logarithmic scale. It’s also one that’s updated through to 2018.
Most notable here is that the more recent bubbles to be found in the modern stock market hardly register as compared to the older more classic bubbles. The very new phenomenon of Bitcoin is more akin to the very old bubbles, but also different. Whereas the old bubbles were of a relatively short duration, Bitcoin has somehow managed to sustain its exponential growth so far over a full decade as mentioned earlier. If Bitcoin is a bubble, it’s surely in a class of its own. Either its a super bubble, or not a bubble at all…. or something in between.
The way forward here I think is to start thinking of Bitcoin as a series of speculative episodes, or mini-bubbles. What strikes the investor on first viewing the chart is not only the pattern-like structure to it, but the way in which the increases [the speculative episodes] heavily correct. Where assets are simply in a bubble, prices are known to keep inflating on the manic episode without solid corrections and until the price becomes unsustainable. Indeed, any proper correction would serve to ‘pop’ the bubble. In Bitcoin instead, as is depicted in the chart below, you see a solid correction after a manic episode, followed on again by a solid correction after a manic episode. One could indeed say you have a series of something that looks like mini-bubbles, but then not bubbles in so far as each episode in the series heavily corrects, where the previous ‘bubble’ is effectively ‘popped’. It is quite something else in the aggregate. Where the speculative excess culminates in a series of punctuated peaks, the corrections serve to provide a baseline of sorts, with this baseline representing a logarithmic growth curve [something that begins with explosive growth but that plateaus over time]. What’s striking here about this developing log growth curve, is that this principle is also a well-known force of nature. It’s as if Bitcoin price were not completely and utterly random riding on the whirlwind of human emotions, but following some rational rule or another, or some trend. And of course, it’s this longer term trend that is going to interest investors every day of the week.
Having started to think of the bitcoin chart as a series of mini-bubbles, it follows that these bubbles themselves are amenable to being compared. Looking at the above chart, we see clearly the exponential moves up and the subsequent corrections, each of which are within the same range, in real terms [relative to the move up], of between 23-38%. Once again, a solid pattern. Individually, these corrections serve to take the heat out of the speculative market; cumulatively, they serve towards an eventual stabilization of price, otherwise known as price discovery - there is an end goal and a logic to it. Note also that the length of time taken for the recoveries back to the previous highs are extending, and also that the overall price channel atop of the curve is converging. All of which further suggests eventual price discovery. In real terms, our mini-bubbles are also amenable to a comparison along the lines of figure 4 above, only this time instead of comparing various bubbles in various assets, the chart will compare various mini-bubbles in the one asset that is Bitcoin.
Here you have the series of mini bubbles, each correcting, and as relative to each other in real terms [in terms of percentage increases on the y axis in the logarithmic scale]. Note that the speculative episodes are reducing in magnitude. It’s as if bitcoin were maturing, or working out some kind of price level, and this is exactly what you want to see if it were to become a more conventional asset among more conservative institutions. Of course this raises the question as to how this chart in the aggregate is possible. How can an asset experience both such explosive and sustainable growth? In my opinion, this is to ask the wrong question. Rather, it is better to think of Bitcoin as a nascent currency, and the chart representing that currency’s capitalization. What you have here [and this is the theory] is something that could potentially approach the market cap of gold due to its monetary properties. Where gold has been capitalized for millennia, Bitcoin may only take a decade or two…. hence the rapid process of appreciation due to its monetary properties.
Another factor that demarcates Bitcoin from bubble proper territory is that most bubbles are financed by access to easy credit. This is how prices become so inflated to exorbitant levels, and why the inevitable crash when it comes is so devastating - bubbles are creatures of leverage. Bitcoin, in the aggregate, however seems to mostly have risen on the back of the capital inflows of cash reserves. Sure, there is speculative and leveraged excess in each manic episode, but the ‘froth’ of this excess is soon skimmed off, so to speak, with the more solid underlying base line as depicted in the chart left as a bedrock.
And even at the time of writing, with the price of Bitcoin just having pushed through the previous 20K limit, we are seeing one such speculative episode with price rising in the parabolic mode of the base [from 10K] with hardly a correction. Of course, once the mini mania gets going, there is no telling how high it can go though once topping out you have a better chance of charting the correction.
The question that this article has sought to answer is whether Bitcoin is a super-bubble. I think this unlikely for the reasons outlined above. Even if investors don’t understand the fundamentals [or worse, find the fundamentals as espoused by the most enthusiastic and certain as near manic], the chart speaks for itself. Given the length of a decade [and how many shorter-term manias last longer than a decade?] , Bitcoin’s seen to be following a trend, and if investors might not know exactly why it does so [the fundamentals], they certainly wouldn’t want to get completely in the way of it. On this basis, it would be rational for the longer term investor to gain some exposure to this new asset class, or should I say, burgeoning currency. Of course, the investor is also going to recognize, in keeping with the uncertainty principle, that it is always logically possible that Bitcoin is a bubble and so will hedge with that in mind.