Is Bitcoin a Bubble?

The November 2017 Edition

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the past five years, the price of Bitcoin has risen from $10 to $6,000. That’s a 600x increase in price. If you invested $1,000, you now have $600,000. There haven’t been many other investment opportunities that have delivered similar returns. With just a quick glance at the chart below, it’s easy to understand why so many are asking themselves, “is bitcoin a bubble?”

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In 2012, when I first learned about Bitcoin, I thought it was too risky to buy. I thought there was a very high probability that it would completely collapse. The idea of an open-source technology currency seemed too outlandish to me.

However, with each year that’s passed where bitcoin has not only not collapsed, but actually increased in price, my sentiment has changed. I became more open to the idea that bitcoin had the potential to change the world, and significantly increase in price along the way.

In an effort to remain open-minded and unbiased, I sought out arguments from investors and technologists on both sides of the now heated debate about bitcoin’s future. I found a wide range of perspectives.

Some of the world’s most successful investors have described bitcoin as “scam,” a “ponzi scheme” or a “bubble.” Other investors, and many bitcoin technologists, seem convinced that it’s the opportunity of a lifetime. The variance in sentiment could not be any more stark.

JP Morgan CEO, Jamie Dimon, thinks bitcoin is a fraud. Fidelity CEO, Abigail Johnson, is mining bitcoin.

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CNBC / Techrunch

I’ve seen price predictions as low as $0 and as high as $500,000.

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Business Insider

In the same week, two of the most successful investors of all time, Warren Buffett and Peter Thiel, shared opposite sentiment.

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Everyone’s looking at the same technology and the same price charts, but coming to completely different conclusions about the future. Some liken bitcoin to the tulip bubble and believe the idea that it will keep rising in price is a mass delusion. Other people believe it will become the world’s reserve currency.

There are a lot of smart people on both sides of this debate. But both sides can’t be right.

To me, the wide ranging predictions are an indication that no one really knows what‘s going on.

In order to determine if bitcoin is in fact a bubble that’s about to pop, we need to first understand what a bubble is. Then, we need to understand how to value bitcoin, and consider the variance between the price and the underlying value.

What is a bubble?

According to Investopedia, “A bubble is an economic cycle characterized by rapid escalation of asset prices followed by a contraction. It is created by a surge in asset prices unwarranted by the fundamentals of the asset and driven by exuberant market behavior.”

In short, the price of the asset rises far beyond it’s actual value as a result of near universal belief that it’s price will continue to rise. Here are three well-documented examples of financial bubbles:

  • Housing in 2008
  • Technology stocks in 1999
  • Tulips in 1637

The price of bitcoin has soared in the past few years, which, according to the definition above, is an indication that it could be a bubble. But does the current price of bitcoin far exceed it’s underlying value?

Before we can answer this question, we need to know the value of bitcoin. Then, we can compare that value to the price and see if there’s a difference.

What is the value of bitcoin?

Investors value “traditional” financial assets using methodologies such as Discounted Cash Flow, which calculates valuation based on the present value of future cash flows the asset will generate, and Comparable Analysis, which calculates valuation based on the price of similar assets, such as a competing company.

But bitcoin is not a company or a stock or a traditional currency or a physical commodity. So I started searching for methodologies specific to valuing bitcoin. I found that some of brightest bitcoin investors and analysts, such as Chris Burniske and Ari Paul, have been working hard to develop metrics and models for valuing crypto assets.

Their models sound viable to me, but I also don’t fully understand how some of the metrics they consider translate to price, particularly in a market where even bad news seems to lead to rallies. I also know that financial models aren’t always accurate. As you throttle the underlying assumptions of the model, you can get completely different predictions. In addition, valuations may not be predictive of price because investors (humans) don’t always act rationally.

I recently found a methodology for valuing bitcoin that makes more sense to me than any other I had found previously. It’s by New York University professor of corporate finance and valuation, and Wall Street’s “dean of valuation,” Aswath Damodaran. In an interview on CNBC, he argued that bitcoin is best classified as a currency, and therefore that “there is no valuation discussion around bitcoin.”

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Damodaran wrote an article on his website that provided a more in-depth explanation for his conclusion:

“bitcoin is not an asset, but a currency, and as such, you cannot value it or invest in it. You can only price it and trade it.”

If bitcoin is best classified as a currency, and there’s no way to value a currency, then there’s no way to know if it’s price far exceeds it’s underlying value. In fact, you can’t value bitcoin at all.

If bitcoin is in fact a currency, then it’s price will largely be driven by supply and demand — buyers and sellers on the exchanegs. In other words, the best metric to track isn’t the Price to Earnings ratio or others like it that are used to value other financial assets, or even bitcoin transaction ratios. Rather, Naval Ravikant, CEO of AngelList, says that the metric to track in order to predict the price is the number of believers:

Chris Dixon, a Partner at a16z, one of the most successful venture capital firms in history, has shared a similar perspective. In an article titled, “What the smartest people do on the weekend is what everyone else will do during the week in ten years,” he wrote:

“Business people vote with their dollars, and are mostly trying to create near-term financial returns. Engineers vote with their time, and are mostly trying to invent interesting new things. Hobbies are what the smartest people spend their time on when they aren’t constrained by near-term financial goals.”

More recently, in an episode of the a16z podcast titled “Why Crypto Tokens Matter,” Dixon described how what the “weekend militia” is working on is often predictive of what technologies succeed, and that there’s clearly a large group of enthusiastic and smart people working on bitcoin projects, and that’s informed his investment strategy.

I don’t see an easy way to value bitcoin, but I do see a lot of smart people building startups to support it, starting blogs and podcasts to help educate the public, running experiments with “Initial Coin Offerings” (ICOs), hard forks, and token sales, and spending their nights and weekends contributing to open-source projects. Some of them weren’t happy with the way the US dollar is being managed, and instead of just complaining about it, they created an alternative that they’re more happy about. Many of them have already made fortunes and expect to make even more.

This enthusiastic community may be a better indicator of bitcoin’s potential than the complicated financial metrics and models.

So, is bitcoin a bubble?

A bubble is when the price of an asset far exceeds the underlying value. But no one knows what the underlying value is or where the price will be in a few days, let alone a few years from now.

To determine if bitcoin is a bubble, consider more than the price, the valuation models, or the opinions of experts. Consider the actions people are taking, and whether nearly everyone is taking those actions or if there’s a healthy balance between bulls and bears. Paradoxically, seeing the “weekend militia” hacking away is probably a case for being bullish, but if nearly everyone was optimistic, it would hit that universal exuberance characteristic of a bubble.

A few years ago, most people had no idea what bitcoin was, let alone believed the price was going to continue to rise. How many of your friends that work outside of technology or finance have been raving about bitcoin? That number has probably increased as the recent bull market has attracted more speculators, but we’re far from a unanimous consensus. I’d be more concerned that bitcoin is a bubble if everyone was saying it isn’t a bubble.

It’s important to consider the perspective of financial experts. But how many times have the experts turned out to be wrong? Just look at the food pyramid.

The price has run up significantly in recent years. But maybe past performance isn’t indicative of future performance, or maybe it will run up even more if more people start using it as a currency.

Governments may try to regulate or even ban bitcoin. But many bitcoin investors are aware of those risks, so maybe that’s already be baked into the price, or maybe even if governments do try to regulate or ban bitcoin, they don’t succeed.

Despite my counters, the bear case is strong, and we don’t have a standard methodology for valuing bitcoin, which is quite scary. There are a lot of smart people who who think bitcoin will eventually be worth nothing. They’ve made a lot more money investing than I have, and their arguments make sense to me. That’s why I think there’s a high probability that this market will completely collapse.

At the same time, while I don’t know what the complex financial models say, I do know what a lot of smart people are “doing on the weekend.” When the price of bitcoin dips after news about regulation, or a financial expert says it’s a bubble, they just seem to double down. And that makes me think there’s a small chance that bitcoin is going to the moon.

This community of rabid bitcoin enthusiasts is small but growing. If on top of that community, a few large financial institutions or many more main street investors become “believers,” I think this market could still have some legs over the long-term…but then it could become a bubble ;)

I’m not a financial advisor and this is not investment advice.

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