NOTE: This June 2018 article discussed the 2018 bear market in the context of 2017’s crazy ICO-driven market rally. As we now (2023) know, most of ICO’s collapsed in the years after this article was published.
What is a financial bubble?
Why do boom/bust market cycles happen?
These questions have been asked ever since the world’s earliest financial markets appeared.
Why do we create such unreal expectations about market movements?
Why are skilled investors, economists, advanced software algorithms, artificial intelligence, predictive models and massive amounts of information unable to stop market crashes from happening?
On average, only the very best fund managers are able to come out with some profit over the years. Most investing fund managers will usually come out even in the long run. And the majority of investors lose money in speculative markets.
Why is this so?
Why are the masses’ expectations so wrong?
It turns out that markets are chaotic – it’s an unpredictable process, like a random walk. Your next step depends on the last, while random events happen along the way and change your path forward.
The best software and the top analysts are unable to predict future movements in chaotic systems.
They have a pretty decent idea of what’s going on, they can hedge their risks and avoid many traps, but as pointed out earlier, only the best actually return a profit over the years.
Yes, it’s possible to hit a homerun, make a bundle of cash and then leave the markets. But most don’t leave, just like in a casino, they come back for more and then lose their initial lucky strike.
Mega investors like George Soros have theorized why markets crash. In his classic “The Alchemy of Finance”, Soros attempts to explain market crashes through his self-developed concept of reflexivity. By his theory, market results and market players influence each other and reinforce a certain consensus until it becomes unsustainable, then it reverses and crashes.
The process of market movements that influence the players who, in turn, influence the markets back in a self reinforcing spiral, is what Soros called reflexivity.
Market results reflect on investors’ expectations and attitudes which in turn generate more actions, normally in the same prior direction, which in turn generate more market signals until it becomes unsustainable and crashes, reversing the movement to the opposite direction.
All this is fine and dandy, but all the above refers to well regulated fiat markets. What about cryptocurrencies?
Take all the speculative, gambling-like behavior of centralized and regulated financial markets and multiply it by 100X. That’s the cryptocurrency reality at the time of this writing (mid 2018). Crypto markets are crazy. There’s no other definition for it. One guy, who we shall not name, admittedly under the influence of drugs, posts something about some crypto and immediately it soars 100%. Some rumour is started by someone and another crypto crashes 90%. Obvious, blatant, screaming Ponzi schemes go by like it’s normal to have 1% daily returns on your dollar investment. Then they crash as is inevitable in any such scheme and investors (gamblers) act surprised.
What we have in the cryptocurrency markets is not a financial bubble. It is financial madness combined with some very real prospects of a revolutionary financial system that is still being built as we speak. It’s very, very early! There are some price distortions, but overall the fundamentals of the cryptocurrency revolution remain solid.
Bitcoins are rare, they are secure and they are very liquid. Bitcoins, therefore, are an excellent investment for the long run if you intend to protect your capital and hold the coins for several years. In fact, whoever did just this in 2010 and 2011 is a very, very rich person today. Speculators and gamblers, on the other hand, have bought and sold their coins early on and did not reap the amazing profits of crypto in the past 9 years. Long term investors are, therefore, on the safer side of the cryptocurrency revolution. There will only ever be 21 million Bitcoins – think about that. Not every millionaire will be able to have a Bitcoin – there are actually more millionaires than there are Bitcoins and that’s a powerful statement.
How about altcoins? In the altcoin space there may be quite a few digital assets which we’d certainly classify as bubbles. A lot of the ICO’s which sprung out of nowhere in the 2016 to 2017 ICO craze will likely go nowhere. Some have already folded and others are still dragging their roadmaps along with little actual progress to show.
But some cryptocurrency projects in the altcoin space show great potential. Cardano ADA is one such project. It is run by experienced people, Charles Hoskinson for one who participated early on in Ethereum and is currently part of Ethereum Classic, a very competent and highly skilled Haskell language development team and a crazy-ambitious project which includes governance, compliance, cross-chain compatibility, environmentally-friendly “mining” (staking) and lots more. Such projects hold the cryptocurrency space together and help maintain serious investors in the space.
Other projects are complete jokes and don’t deserve mention. Suffice to say some ICO’s plain simply disappeared right after collecting millions from unsuspecting victims. Others are just boiler rooms with no real developers, they just keep dragging the project along, fooling investors that something is happening behind the scenes, while the scammers are spending all the money in Fiji. These scams give the whole ICO space a bad name and it’s precisely because of such schemes that regulators from around the world have their crosshairs set on crypto.
A financial bubble can be defined as the sum of unreal collective expectations which lead price/earnings multiples that place equities well beyond their capacity to pay for themselves in a lifetime. When the stock market as a whole is operating at such multiples, which will not bear fruit for the life of present day investors, questions begin to be asked. “Why is everyone continuing to buy at these prices? What is the point? At these prices I’ll never make my money back!”. Such questions lead to a pause in the upside movement. This pause is where experienced investors jump ship. The masses have noticed that there isn’t logic in continuing to buy something that will never pay for itself.
It is important to note that the previously dominating market behavior will have crossed the point of logical investing, into crazy speculative territory, without noticing it. P/E multiples aren’t watched during trading, ticker tapes are. Investors easily embark on senseless buying sprees with no logic, based on smoke signals, esoteric beliefs and other illogical behavior.
Cryptocurrencies, on the other hand, may have traits of a bubble in general, but the solid ones aren’t. Bitcoin is definitely not a bubble. Some cryptos definitely are bubbles and others are downright scams. Investors should carefully weigh their options, perform due diligence and investigate the origin of ICO projects, who is behind them, what their real purpose is and whether there’s a competent team of developers who are able to lead the project forward after the ICO. If you’ve invested in IPO’s before, if you’ve been around the stock market, the scammy ICO’s sort of jump at you right when you see them. Seasoned stock investors will immediately identify a boiler room project when they see one. But too many cryptocurrency investors are young, idealistic and inexperienced. A lot of young investors can’t tell a scam from a serious project, which is where unfortunately authorities will end up having to regulate some of the ICO space.
In short, Bitcoin is a very solid project, with an amazing team of developers behind it. Source code is the law, the system is self regulating and so far, in over 9 years operation, Bitcoin has proven that it is capable of overcoming the most sinister technical attacks that any technology has ever withstood. Therefore Bitcoin is not a bubble in our opinion, but crypto investors should be very careful when placing their money in altcoin projects.
Original Image Credit: Serge Melki from Indianapolis, USA