As 2017 draws to a close it is fair to say that the past 12 months were not especially kind to the bears. Global equities, despite looking expensive on standard valuation metrics, generated double-digit gains in developed markets (EAFE Index +19%) while emerging market equities recorded even stronger gains (EEM Index +27%).
Adding to the misery for the bears, the sell-off in bonds witnessed in the final weeks of 2016 failed to evolve into the multi-decade trend reversal many investors anticipated it would.
Thankfully, one was on the right side of these market moves (the currency calls were less successful – the JPY and GBP both displayed resilience one did not anticipate given the profound change to BOJ monetary policy operations in the case of the former, and extremely messy Brexit negotiations in the latter).
However, one’s stellar call of the year was, undoubtedly, bitcoin. It is not often an analyst can attach their name to favourable market move which in percentage point terms has three zeros in front of the decimal place.
After contemplating this year’s market moves what is clear to us is that many investors and financial market commentators do not fully understand speculative asset price bubbles or their associated components. After all, market prices seemed blissfully unaware of the plethora of articles in the financial media over the past 12 months containing bubble warnings for stocks, bonds and especially (and more recently) bitcoin.
Former Fed Chairman Alan Greenspan famously argued that it was difficult to identify asset price bubbles ex ante, which was part of his justification for pursuing a “clean versus lean” approach to monetary policy. However, this is far from obvious when one considers a standard definition of a speculative asset price bubble (courtesy of Investopedia).
“A speculative bubble is usually caused by exaggerated expectations of future growth, price appreciation, or other events that could cause an increase in asset values. This drives trading volumes higher, and as more investors rally around the heightened expectation, buyers outnumber sellers, pushing prices beyond what an objective analysis of intrinsic value would suggest.”
Based on this definition there are three key ingredients for a speculative asset price bubble:
- strong positive price momentum (price appreciation)
- high sentiment (exaggerated expectations)
- fundamental overvaluation (beyond intrinsic value)
Of the three, strong price momentum is the most visible and, as a result, it tends to be the one that most financial market participants focus on when deciding whether an asset price is in a speculative bubble or not.
However, as bitcoin has repeatedly demonstrated, this is a flawed approach.
A Market Insight published earlier in the year included a series of charts plotting the evolution of bitcoin’s price since 2012. It showed that over this period there were three occasions when its price rose exponentially (incorporating the latest move there are now four occasions). In each of the three previous occasions, there were fairly significant corrections but the underlying trend remained firmly upwards.
Exhibit 1: A Bitcoin Bubble …Now …Now …Now …Or Now?
Source: Quandl
Source: Quandl
Using the bbitcoin example shown in the exhibit above, the salutary lesson for investors is that exponential price dynamics are an incredibly inexact tool by which to assess whether there is an asset price bubble and, more importantly, whether the bubble on the cusp of bursting.
It has to be considered along with the other ingredients, that is to say, sentiment and fundamental valuations.
Of these two additional elements, one is well-positioned to assess the former using the crowd-sourced sentiment indicators. Indeed, it was instrumental in keeping us bullish earlier in the year. As one noted in the aforementioned article:
“When we look at crowd-sourced sentiment towards bitcoin it has been rising recently (positive sentiment momentum) but is far from extreme when compared with previous sentiment peaks. The absence of a strongly positive sentiment reading is important as it strengthens the conviction that bitcoin is not in bubble-territory.”
The crowd-sourced sentiment indicators were also critical in keeping us bullish towards equities, especially in the US. Equities may well have been overvalued, and hence ticked one of the boxes in the bubble list, but crowd sentiment was generally subdued – see exhibit below.
Exhibit 2: Crowd Sentiment vs. Price – US Equities
Source: Amareos
Simply put, there was not a sense of, to borrow Greenspan’s phrase, “irrational exuberance”.
This was a perception not readily apparent to investors who use market prices, such as the VIX implied volatility index, as a proxy for sentiment. Indeed, consider CNN’s composite price-based US equity sentiment indicator, which as shown in the exhibit below has been in “Greed” territory for much of the year – (more fake news perhaps!).
Exhibit 3: CNN’s Fear And Greed Index
Source: CNN Money
The key takeaway from these two examples is that to conclude that an asset price is in a bubble, one whose imminent bursting will create exploitable shorting opportunities, requires all three ingredients to be present.
Looking at the latest sentiment readings for global equities – see exhibit below – what is apparent is that the double-digit gains witnessed over the past year has generated a more positive hue to the sentiment heatmap. However, across the major indices sentiment is far from extreme, suggesting that the bull market still has legs. (NB: Swiss, Indian and Hong Kong stocks have historically elevated crowd sentiment readings indicating a less constructive assessment).
Exhibit 4: Global Heatmap – Equity Indices
Source: Amareos
What about bitcoin, the financial asset (a label many would quibble about as proof of the fact that bitcoin really is digital gold and like its naturally occurring equivalent is financial marmite – you either love or hate) where bubble speculation is at its greatest?
Some 60 days and $10,000 higher than when one last published on bitcoin signs of over-exuberance much clearer. As shown in the exhibit below, crowd-sourced sentiment towards bitcoin has risen to its highest levels seen since the cryptocurrency began to receive mentions beyond the geek world.
Exhibit 5: Crowd Sentiment vs. Price – Bitcoin
Source: Amareos and Infrotrie
On this basis, and unlike earlier in the year, there is considerable frothiness of optimism on the part of the crowd which has, unquestionably in one’s view, been a key factor driving the price of Bitcoin higher. In that sense, RBS Chairman Howard Davies, who deployed Greenspan’s phrase “irrational exuberance” when describing recent price moves in bitcoin is fully justified.
Given this, one expects there to be a fairly significant downward correction as, or more probably when, crowd sentiment momentum starts to fade. Looking at previous episodes, a pullback of around 30% would not be an unreasonable expectation – an eye-watering magnitude for those on the wrong side of it. Certainly, now is clearly not the time to be jumping on the bitcoin bandwagon.
Exhibit 6: Crowd Sentiment vs. Price Drawdowns – Bitcoin
Source: Amareos and Infrotrie
Does this also mean bitcoin is unquestionably in a bubble? As mentioned, two of the three ingredients for a bubble – excessive optimism (exuberance) and strong positive price momentum – are present. The third ingredient – fundamental overvaluation – is much a much trickier proposition to assess.
For those who think that bitcoin is nothing more than a hi-tech Ponzi scheme that relies upon the greater fool theory (presumably given its recent price dynamics there are a lot of them around) any value above zero is fundamentally overvalued. On this basis, bitcoin is the shorting opportunity of a lifetime. That said, with price momentum so strongly positive, timing is everything. (This is a truism in investment, but the dangers of getting it wrong in bitcoin’s case would be extremely toxic to one’s financial health.)
One finds such arguments less convincing.
In an earlier piece, one outlined the approach to generating a fundamental valuation for bitcoin. One deployed a technique Tetlock and Gardner in their book Superforecasting called Fermi-ising, which breaks down a complex question into its component parts. This approach, they found, often generates superior predictions, especially when information is either unknown or missing. The same technique underpins the Drake equation that seeks to provide a framework for encapsulating all of the relevant information to calculate the number of intelligent civilizations that existed in the galaxy (a bitcoin valuation seems positively tame compared to that).
In the case of bitcoin the equation looks like this:
BIT_fv = (S . 1/N . R . C) / B
BIT_fv = Fundamental value of bitcoin
S = Stock of global fiat money
N = Total number of cryptocurrencies
R = Ratio of bitcoin’s market share to average cryptocurrency market share
C = Ratio of cryptocurrencies/fiat money
B = Total supply of Bitcoin
The outstanding stock of fiat money and the finite number of bitcoins are both known numbers and serve to provide a crucial valuation anchor. The other three variables upon which the valuation relies need to be estimated and they are:
- How much money will the public hold in virtual form?
- How many cryptocurrencies will there be?
- What will bitcoin’s market share be?
Assuming 10% of money will, eventually, be held in virtual form and that there would be 10 virtual currencies each having an equal share, one estimated the fundamental value for bitcoin at $29,000. However, using the latest estimate for the stock of global fiat money ($83.6trn) and also taking into account that a recent study by Chainalysis that between 2-4 million bitcoins have effectively been lost, the fundamental estimate for bitcoin using the same assumptions rises to $46,000.
Either way, this is substantially higher than the current market price of bitcoin – and hence suggests that short-term froth aside bitcoin is not a bubble.
Obviously, this approach relies on some fairly heroic assumptions, but how plausible are they?
The ratio one is most confident about is that there will be no more than around 10 globally traded cryptocurrencies.Given there are currently close to 1,000 in existence this seems like a big call. However, when one looks at trading activity of the 180 fiat currencies in the world today, what stands out is the very uneven distribution.
The latest data on OTC annual turnover from the BiS triannual FX survey (2016) show four currencies – USD, EUR, JPY and GBP – dominate (see exhibit below). Collectively they occur in more than 150% of all transactions (the data reports whether the currency was included in either leg of the transaction and hence the aggregates sum to 200% not 100%).
Exhibit 7: FX OTC Volumes – 2016
Source: BIS
The comparison one is about to make may appear at first glance to be apples to oranges – one is based on turnover and the other is market capitalisation – but as both reflect the impact of network effects one considers it to be legitimate. Indeed, looking at the distribution of market capitalization for cryptocurrencies one sees a similar profile with the top ten cryptocurrencies accounting for almost 90% of the total – see exhibit below. Of these, bitcoin is by far the largest at approximately 60%.
Exhibit 8: Cryptocurrencies By Market Capitalization ($ bn)
Source: Coinmarketcap
Even if hundreds, or thousands, of cryptocurrencies are in existence, network effects will ensure that only a handful dominate and, as evidenced by its current high share of market capitalization, bitcoin has a strong first mover advantage.
Given that, it would appear that, if anything, there is upside risk to one’s assumption of bitcoin having a 10% market share of all cryptocurrencies – possibly by orders of magnitude. With every percentage point increase in bitcoin’s share of market capitalization (using the old economists ceteris paribus trick) adding $4,600 to its fundamental value, it is not hard to understand some of the seemingly more extreme price predictions. (A 50% market capitalization would imply a fundamental value north of $200,000).
Regards the final assumption, the ratio of virtual currencies to fiat currencies held by the public, this is the one one is least confident in guessing. The total market capitalization of all cryptocurrencies stands at 0.48%. The 10% ratio feels about right but even if one assumes that one is too bullish and cut it in half, to 5%, it would still imply a fundamental value for bitcoin of around $23,000 assuming all of the other assumptions are unchanged. (FYI: The break-even cryptocurrency/fiat currency ratio based on today’s bitcoin price would be 3.5%).
To reiterate, the point of this exercise is not to generate precise valuation estimates for bitcoin – that is practically impossible. It is to provide a practical framework for thinking about how to value bitcoin, or any other cryptocurrency for that matter. Plugging in assumptions that appear reasonable (at least to us) generates numbers that exceed current prices, demonstrating that it is far from certain that, even with frothy investor sentiment and recent exponential price gains, bitcoin is in a bubble.
That said, if one is not in a bubble yet, one is sure there will be one in the end. As Didier Sornette noted in his working paper referenced in above a bubble starts with a new opportunity or expectation, which could be a groundbreaking new technology or access to a new market. Bitcoin, and the other cryptocurrencies, qualify on both counts and in that sense are ideally suited to bubble price dynamics -we just might not be at that point yet due to the fog relating to how to fundamentally value them.
Finally, as discussed, short-term one sees bitcoin’s price dynamics being driven by a sentiment battle. Longer-term the battle will be between investors in the cryptocurrency world and governments loath to give up their monetary sovereignty.
Media headlines already make clear that policymakers are becoming concerned about their usage and in a recent CNBC interview Jamie Dimon (hardly a fan given his previous comments on bitcoin) said:
“No government will ever support a virtual currency that goes around borders and doesn’t have the same controls. It’s not going to happen.”
We don’t always share Dimon’s views on bitcoin, but on this aspect, he is spot on. There is a regulatory risk element to consider.
However, banning bitcoin or other cryptocurrencies is far from straightforward given the borderless nature of the internet. To be successful it would likely require coordinated action at a global level and such things take time. Moreover, the greater the market capitalization of cryptocurrencies (including bitcoin) and the wider ownership becomes, the more politically difficult it will be to deal with the losses generated by banning their usage.
In the end, perhaps this is why bitcoin is so important. Not because it could be the latest in a long line of speculative asset price bubbles, but because it represents the bulwark between centralised, hierarchically structured governments and decentralised nonhierarchical networks. One judges it to be the opening salvo in a much more important battle.
The post Bitcoin: Anatomy of a Bubble? appeared first on The Market Mogul.
