The Bitcoin Bubble Fallacy: why even the most prestigious investment banks may be wrong.
An article that discusses the essence of evaluating the hypothesis that Bitcoin is in a bubble and why real objectivity is key.
It’s important to recognize when you are in uncharted territory; even subtle differences can be meaningful indicators to reflect upon. By now you’ve likely heard about Bitcoin and witnessed its impressive growth. You’ve probably also read about other cryptocurrencies skyrocketing 1,000% or even 10,000%+ in very short periods of time. Hearing how everyone around you is making money and why this or that project is the next big thing. Sounds familiar, doesn’t it? BUBBLE! I’m always skeptical of this word because it implies fear; fear of the inevitability of the bubble bursting. Stories or discussions around the word typically focus on narrow definitions of market bubbles that emphasize emotion and confirmation of the bubble rather than the subtle differences between them.
While this article focuses on the foolishness in comparing Bitcoin to historical market bubbles, there are other models used for interpreting Bitcoin price appreciation that do seem to function better, some of which are linked below:
What does “bubble” refer to? The term “bubble” and its definition/context is likely different for everyone and, thus, your personal usage of the term can and will affect the interpretation of this article. This article is referencing “bubble” as it is being thrown around in the media, whereby the parabolic rise of Bitcoin to $20,000 USD is seen as the extent of the current bubble, which is on the edge of popping.
After reading through tweets, articles, and listening to various podcasts you’ll be able to place most of the most weathered investors and traders into two main camps. Either (1) those that won’t touch Bitcoin et al. with a 12 foot pole because it’s obviously a bubble/mania or (2) those that feel compelled to talk about it because it’s HOT, but remain largely neutral. Very few are willing to fairly define the pros and cons of this new asset class. Very few are willing to take the ebb and flow of the market in stride and view them with an open mind, free to be evaluated objectively. Fundamentalism on either side (zero or hero) can be blinding and will probably have a negative impact on your account.
Wasn’t this article about some BUBBLE? What’s the point already?!
The points that I danced around in the preceeding paragraphs are:
(1) If it looks like a duck, quacks like a duck, and acts like a duck, then it might be a duck.
But what happens if you observe the creature (“it”) in question and it does something that a duck cannot do? It cannot be a duck. This is the conclusion of real value. Of course this assumes your sample size of duck appearance/behavior is sufficiently large to have some handle on the distribution of duck characteristics. To make the connection, if Bitcoin et al. look like a bubble (see image below), sound like a bubble (people getting rich quick), and act like a bubble (volatile growth and correction), then it might be a bubble. I don’t want to linger here too long because there are many great pieces out there discussing why aspects of the cryptomarket are more bubble like than others.
The bottom line is be wary of confirmation bias — evidence that confirms your hypothesis does not necessarily prove your hypothesis to be true; merely that it is not wrong based on the evidence thus far.
This is especially important for looking at markets because humans naturally look for similar patterns to confirm their analysis. Don’t get me wrong, there is power in this practice (Technical Analysis) but only when practiced with an open mind — one completely open to the opportunity of the market moving counter to your reference point. More on reference points, the lynch pin for this article, later.
(2) Instead of focusing on what you “know” to be true, presumably based on some historical metric or personal experience, focus on (a) why your hypothesis is wrong and/or (b) what other scenarios can play out, how they might look, and how you can (and should) prepare for their eventuality.
These points draw from one of the books I’ve been reading through lately, The Black Swan by Nassim Nicholas Taleb, which provides excellent perspectives on these topics and many more; my discussion doesn’t do the points full justice, so if you’re interested in these topics further I would advise you to read them straight from the source for yourself.
Reference Points
The title of this article implied there was something missing about many of the bubble references we’ve seen in the media and touted by top investment banks, regarding cryptocurrencies. What’s my interpretation of these pieces? Their frame of reference is usually wrong or biased, focused on supporting their outlook.
Let me try to break it down into the following framework.
Classification. First off, it is important to distinguish a Bitcoin bubble from a cryptomarket (Bitcoin + all others) bubble. From my perspective, we’re closer to the latter, not the former. While I won’t go deep into the reasoning behind why, it’s mostly because Bitcoin is itself still an evolving network, technologically and practically. This means that the limitations it faces now can largely be overcome in the future. There are plenty of articles discussing Bitcoin scaling, etc., so please look them up if you want to read further. Suffice it to say many of the other coins out there do not add real value that Bitcoin can’t add itself.
The hypothesis. Bitcoin is in a bubble and will not survive, just like every other market bubble.
How do we prove or disprove this hypothesis? Unfortunately, we cannot resolve this either way until time passes and so, in reality, no one knows whether Bitcoin is in a bubble or not. However, we can construct models and discuss their validity to shed some light on the matter.
The evidence. The majority of evidence people provide to support this hypothesis is a comparative analysis with known bubbles; the charts largely focus on raw price movement or discrete periods of time surrounding their significant rise/fall/maximum. Note some of the following below and attached notes from a recent publication. These are only a couple of recent examples, but most of them are likely to exhibit similar punchlines.
Going back to my initial discussion, let’s consider why this hypothesis (Bitcoin is in a bubble) may be wrong. The “bubble” is compared to the notorious tulip prices (Gouda Variety), where it is implied Bitcoin price appreciation is even more exaggerated than even tulips, and of course the Nasdaq peak. This means it’s “worse” this time around. There is something being ignored here in these simplistic comparisons that do not present the data in an objective way. It’s called a reference point and the one this group chose was the “height” of the bubble. There’s a couple of issues here, discussed below:
Bitcoin Bubble Hypothesis Issue #1 — A Guessing Game How do we know we’re at the height of a presumed Bitcoin bubble? As stated previously, it is irrational (impossible) to conclude we are at the height because we simply don’t have the data to provide evidence for it — wait another 5, 10, 20, or maybe 100 years, and then we might be able to prove this hypothesis holds water. But, for now, this type of analysis/reference point could have been made back in 2013–2014 — and that would have been a major lost opportunity (see chart below).
Bitcoin Bubble Hypothesis Issue #2 — Comparing Apples to Hot Dogs The other issue with the comparison to the tulip bubble or any equity bubble thus far is equally important. Notice the start point for each bubble. It’s based on an arbitrary assignment of the current Bitcoin high ($20,000 USD), +/- 2 years. Comparing Bitcoin to any of the indexes shown here is foolish, because one is comparing an “asset” that has existed for approximately 9–10 years to baskets of assets existing for 50+ years; apples to oranges, no… hot dogs. And tulips? I’m not sure about you but I have yet to find a way to propagate my Bitcoins by planting them (i.e., tulip supply can be increased over time. During the mania, demand of specific tulips temporarily exceeded their supply, but inevitably those tulips could be supplied). You can fork Bitcoin and you can create other coins of course, but the network supporting Bitcoin has largely stayed in Bitcoin, whose final amount is finite. This is relevant to why the cryptomarket at large can be considered more of a bubble than Bitcoin itself.
Going back to Goldman Sachs’ comparative charts above, which considers Bitcoin from approximately 2015 when it was around $500 USD per Bitcoin, yielding an approximate 4000% increase over this time. But let’s be objective about the data — if we consider Bitcoin performance since inception, which approaches $0.00, then we have a near infinite percentage increase from the beginning. Talk about a BUBBLE! OK, so via BitStamp we can see in 2012 it was around $2.50, for a much more reasonable 800,000% to the bubble top ($20,000). Hopefully you’re starting to catch the point here — looking at raw percentage increase is somewhat foolish because, to make things fair, we need to consider the rise from its starting point, such that we can normalize the data to make comparisons.
When we do this, we get astronomical rises because something (Bitcoin USD valuation, for example) was born from nothing (code, valueless if we consider it akin to writing on paper — not a dig at developers! Merely from the standard point of view that value comes from practical usage — consider it similar to a book that is unread by anyone other than its author).
Think about that. Almost everything that has been bought or sold can be tracked back to its original identification as something valuable (whether that value was realized as practical or aesthetic) — before this time (realization of value) it would be considered valueless (zero) and therefore its value appreciation resulted in exponential or near infinite increase in value (hero). Consider Vincent van Gogh, whose artwork was largely valueless during his life but whose work is now highly sought after, fetching millions; again, near infinite rise. Bubble?
So, what falls out from these perspectives?
“Bubble” is not a good name for the current Bitcoin market; it implies there will be a definitive point in time when it will burst and never rise back to its maximum price. The volatility we see in the exponential rises and corrections over the years in Bitcoin exemplify human nature well; cycles of greed and despair. Does this mean it will never have its bubble moment? No — perhaps that day will come. But, what is your opportunity cost by ignoring it?
As an aside, I would like to point out that the intention of this article is not to bash others’ work that was mentioned here; simply to provide reasons why it might be wrong. This should be at the heart of any analysis — why might I be wrong, and what might that mean? For instance, I have already thought about why I might be wrong (say, Bitcoin is done and on the way to zero) and what I can do about it — it’s implied below. But, simply, I have gone on the defensive — locked in profits and outlined a strategy moving forward. I’m perfectly happy if Bitcoin goes to 0 or 100,000 by the end of the year. You should be too, and if you’re not, you may want to focus on wealth preservation strategies as they will be a tool for life.
The majority of this article has been rather philosophical in nature, but I would like to leave you with a few practical points to navigate Bitcoin et al. in the coming year.
Risk management is at the top of the list of what you should focus on if you would like exposure to an asset class like Bitcoin whose future is wholly uncertain but, potentially, very rewarding. For example, determine a percentage of your investment portfolio that you’re OK with risking on Bitcoin, which could go to zero at some point in the future. Now take that percentage and divide it up into some fraction. Maybe 1/3’s or 1/4’s, depending on your personal outlook. Spread this investment out over a year — dollar cost average in — meaning buy some now, buy some in the Summer, buy some next year. This will allow you to weather potentially significant corrective moves down (like the ones seen in 2013–2014). If it goes up after your first entry, you’ll be happy because you’re profitable. If it goes down, you’ll be happy because you have cash to have a better cost average.
On top of the above — please think about your time horizon for your investment and consider the Bitcoin market over the past 10 years — it’s been quite the ride, but here we are today, considering if we can safely call it a bubble again (probably not). Even if you’re not convinced it’s going to keep going and you don’t feel compelled to invest in it, check on it in 6 months, and then another 6 months. You might be surprised. Again, most of my perspective comes from my willingness to be open to opportunity, not expect any specific outcome.
I hope this article provided some incremental insight or an alternative perspective for you, as that is the major intention here. Please keep in mind this article in no way should be used as financial advice. It is for information purposes only and the opinions expressed here are mine alone and not intended to be used as a source of investment advice.
