Back in September I wrote a post entitled “Should You Speculate in Bitcoin?“. The not-so subtle hint in the title is that Bitcoin should not be viewed as a typical investment, but as a form of speculation.
There is always a chance to make money by speculating in something at the beginning of a run, but most people end up losing most of their funds by the end. In my Bitcoin post I gave 4 reasons why you should not gamble in Bitcoin and how it could end up getting slammed. Since that time Bitcoin has continued its meteoric rise and the mainstream media has feverishly covered the story.
Anatomy of a Bubble
The following figure by Dr. Jean-Paul Rodrigue of Hofstra University shows the anatomy of a bubble. The 4 phases are described as the Stealth Phase, Awareness Phase, Mania Phase, and Blow off Phase. These phases can be applied to several historical bubbles going back hundreds of years (ie. Tulip Craze, Japanese Stocks, Internet Bubble, Housing Bubble, etc).
Minsky’s 5 Stages of a Bubble
Hyman P. Minsky, an economist famous for his financial instability theory, came up with 5 stages of a bubble. Investopedia has a good article listing Minsky’s stages:
Displacement: A displacement occurs when investors get enamored by a new paradigm, such as an innovative new technology or interest rates that are historically low. A classic example of displacement is the decline in the federal funds rate from 6.5% in May, 2000, to 1% in June, 2003. Over this three-year period, the interest rate on 30-year fixed-rate mortgages fell by 2.5 percentage points to a historic lows of 5.21%, sowing the seeds for the housing bubble.
Boom: Prices rise slowly at first, following a displacement, but then gain momentum as more and more participants enter the market, setting the stage for the boom phase. During this phase, the asset in question attracts widespread media coverage. Fear of missing out on what could be an once-in-a-lifetime opportunity spurs more speculation, drawing an increasing number of participants into the fold.
Euphoria: During this phase,caution is thrown to the wind, as asset prices skyrocket. The “greater fool” theory plays out everywhere.Valuations reach extreme levels during this phase. For example, at the peak of the Japanese real estate bubble in 1989, land in Tokyo sold for as much as $139,000 per square foot, or more than 350-times the value of Manhattan property. After the bubble burst, real estate lost approximately 80% of its inflated value, while stock prices declined by 70%. Similarly, at the height of the internet bubble in March, 2000, the combined value of all technology stocks on the Nasdaq was higher than the GDP of most nations. During the euphoric phase, new valuation measures and metrics are touted to justify the relentless rise in asset prices.
Profit Taking: By this time, the smart money – heeding the warning signs – is generally selling out positions and taking profits. But estimating the exact time when a bubble is due to collapse can be a difficult exercise and extremely hazardous to one’s financial health, because, as John Maynard Keynes put it, “the markets can stay irrational longer than you can stay solvent.” Note that it only takes a relatively minor event to prick a bubble, but once it is pricked, the bubble cannot “inflate” again. In August, 2007, for example, French bank BNP Paribas halted withdrawals from three investment funds with substantial exposure to U.S. subprime mortgages because it could not value their holdings. While this development initially rattled financial markets, it was brushed aside over the next couple months, as global equity markets reached new highs. In retrospect, this relatively minor event was indeed a warning sign of the turbulent times to come.
Panic: In the panic stage, asset prices reverse course and descend as rapidly as they had ascended. Investors and speculators, faced with margin calls and plunging values of their holdings, now want to liquidate them at any price. As supply overwhelms demand, asset prices slide sharply. One of the most vivid examples of global panic in financial markets occurred in October 2008, weeks after Lehman Brothers declared bankruptcy and Fannie Mae, Freddie Mac and AIG almost collapsed. The S&P 500 plunged almost 17% that month, its ninth-worst monthly performance. In that single month, global equity markets lost a staggering $9.3 trillion of 22% of their combined market capitalization.
Is Bitcoin a Bubble?
While it’s too early to tell if Bitcoin is a bubble since it has only gone up in price over time, we can still examine what it’s done so far.
I would argue that Bitcoin has already gone through the Stealth and Awareness Phases (or Minsky’s Displacement and Boom stages). First it started off as a new technology that only a select few knew about but since then it has gained steam.
I would also argue that Bitcoin has gone through the Mania Phase or Euphoria Stage since it has experienced over a 1000% hyperbolic gain in 2017 alone. Not a day goes by without some young speculator in Bitcoin claiming that Bitcoin is a paradigm shift to global currencies and “this time it’s different”. Check out this comment on a post about speculative investments by Financial Samurai:
I find it interesting to read so many comments talking themselves out of cryptocurrencies. This is a technology that is disrupting the entire financial sector. The rise is not attributable to ‘Greater fool theory’ or whatever else people want to pin it on. Blockchain doesn’t conform to conventional investment vehicles’ movements because it’s not a conventional investment vehicle. This is the black swan event that will transfer an incredible amount of wealth to those who bothered to learn and understand the space.
My guess is that we’re getting close to the end of the Mania Phase and entering the Blow off Phase or Profit Taking stage. The institutional investors that have been long Bitcoin will probably lock in their gains while the public gets burned. There is also the threat of hackers who can decimate the various cryptocurrency exchanges.
Bottom Line. Bitcoin appears to fit the same pattern as other bubbles throughout history. While Bitcoin may continue to rise in value, most likely it’s only a matter of time until it begins a steep decline. If you insist on speculating in Bitcoin, know the risks and be careful.