How can we identify a bubble in the cryptocurrencies market?

Introduction

Before we answer the question of this post, we should know what a bubble is. This way, we will be able to know if the cryptocurrencies, with Bitcoin as their greatest representative, fit this concept. We will use the definition provided by Robert J. Shiller, Nobel Prize in Economics and the author of “Irrational Exuberance”. According to this author, the bubbles are:

A situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a larger and larger class of investors, who, despite doubts about the real value of an investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement

Rober J. Shiller, Nobel Prize in Economics

In this sense, Rober Shiller is not the only person who has defined Bitcoin as the “best example of a speculative bubble”. Some other great economists such as Paul Krugman or Joseph Stiglitz share this opinion. They also consider totally unjustified the increases in the price which Bitcoin experimented through 2021. However, for every detractor we can find one investor which claims that Bitcoin brings the revolution for the financial markets, and therefore, every increase in its price is perfectly fair.

History of the bubbles

Apart from a correct definition, it is also useful to know real-life examples of some bubbles along the history. It is not always easy to distinguish between a bubble and just a bullish trend in any financial asset. Sometimes, it is just the historical perspective which give us a clue about the real bubbles. We will explain now the three most famous bubbles in history. This way, we will be able to recognize the common elements, if any, with the behavior of Bitcoin and other cryptocurrencies along 2021.

Bubble of the tulip mania

We can consider the tulip mania as the first speculative bubble in history, as it happened around the third decade in the XVII century. The tulips became really attractive to the population of the Netherlands due to the exoticism of their flowers and the success of the Dutch East India Company. In fact, the flowers became a symbol and a representation of the wealth for most of the families. The interest of the investors was so high that the highest price someone paid for one single bulb of tulip was equivalent to several years’ salary.

During the first years (until 1635 approximately), the price of the bulbs kept growing without control. In 1636, the bubonic plague reduced to one tenth the population of Netherlands, which initially hit again the prices. The investor attraction led the financial system to the creation of a futures market for tulips, which was something incredibly advanced at the time.

The increase in prices seemed unstoppable, until one day in 1637 when a lot of tulip bulbs did not find any buyer. That situation was the burst of the bubble. Among the triggering reasons, the economists mentioned the rumors about a possible collapse of the market after 3 years of growing prices. From that moment on, all the people sold their assets, the prices sank and the investors lost their savings.

Dot-com bubble

There is another great example of speculative bubble, but much more recent. At the end of the XX century, with the appearance of the Internet, the popularity of the tech companies got triggered. There was a great expectation on the possibilities of the Internet related businesses, and that caused an overvaluation of the shares’ prices. A lot of companies were listed collecting millions of dollars, and everyone wanted to participate of the benefits.

The former president of the FED, Alan Greespan, warned about the existence of irrational exuberance in the market. The Nasdaq 100 Index, which includes the 100 biggest american companies of the tech sector, kept growing. Everything was representing a huge fever for the technological sector. The truth is that the real value of the companies was clearly below the current price of their shares. Warren Buffet says that “price is what you give, value is what you receive” to justify any investment. Apparently, the investors overestimated the real value of these companies.

At the end of 2002, the bubble burst, and several of the most promising companies went bankrupt. The valuations started their decrease, and soon the rest of the market took the negative trend. The first economic crisis of the century just started.

Subprime mortgage bubble

The last (and also the most severe) financial crisis in the economic history also took place due to a speculative bubble, which exploded in 2008. It had its conception in the USA, but it spread rapidly to every economic system in the world. During the precedent years, most of the financial entities in the USA granted mortgage loans without the appropriate supervision. A lot of individuals with no credit quality at all got their money, and the real state market grew without control. These mortgages were called “sub-prime” due to the risk they had implicit.

Additionally, several entities used these loans to create complex investment products with lower quality. The rating agencies did not value properly these products, and the risk became higher. As a consequence, several investment banks around the world invested in these assets.

When the insolvent borrowers did not meet the payments, these products lost their value, and the balance sheets of the entities were affected. In 2008, Lehman Brothers, which at the time was the biggest investment bank in the world, went bankrupt. Most of the clients sold their investments, and they lost all their value. This was the beginning of the economic crisis which affected the entire world economic system for the following years.

The data

In the world of cryptocurrencies, we have experienced some situations which remind us the mentioned bubbles. In February 2021 Elon Musk announced the purchase of Bitcoin for $ 1.500 millions. The very same day after the release, the price of Bitcoin went up 17%. This is just an example of how easily someone could impact the price of cryptocurrencies when their real value remained the same. However, it is also true that Bitcoin has grown a lot in the last years, and not just in terms of economic valuation.

Since their appearance, the cryptocurrencies have been mainly traded by individuals more than by institutional investors. Their advertising is not only present in the financial system, but also in other environments. In fact, the Spanish regulator has launched a public survey to determine the limits of this advertising. Moreover, the use of cryptocurrencies as payment methods has been increasing in the last months. Let’s see some of the main goals achieved by Bitcoin in 2021 to get a complete snapshot of its status.

  • The price of Bitcoin grew up to 76% in 2021
  • More than 100.000 companies around the world accept Bitcoin as payment method
  • The daily number of trades in its network is 285.000
  • The annualized price volatility of Bitcoin goes over 100%
  • One third part of the whole mined bitcoins have remained untraded for the last year

With this data, we can think of several reasons why Robert J. Schiller considered a bubble in Bitcoin during 2021.In fact, we can also list and measure some elements to identify more clearly the speculative bubbles. On the other side, there are also some elements to consider the performance of Bitcoin as not speculative. Let’s see them all.

Classic elements of bubbles

The below elements are not exclusive of bubbles but common in all of them. Every investor should care about them before taking any decision.

  1. High level of volatility – the annualized volatility of Bitcoin is close to 114% which is almost 10 times higher than other assets. The equity investment volatility, for example, is around 20%. This level of high volatility is not a reflection of the increase in the intrinsic value of the asset, but the movement of the investors sentiment.
  2. Vertical increase of the price – there are very few financial assets in the world which can presume of the annual performance of Bitcoin. The increase of 76% in just three months, after the increase of 1000% in 2021, seems really hard to justify.
  3. Sentiment untied of the intrinsic value – some of the biggest daily rises in Bitcoin prices happened for no solid reasons. The rumors on social media, for instance, should not have such an impact in the price of any assets.
  4. Price over value – the evolution of the cryptocurrencies as payment methods has not found stable solutions for their problems. Although the number of companies accepting Bitcoin keeps growing, the truth is that it remains unscalable. In fact, most of the individuals owns Bitcoin as an investment, not as a payment method.
  5. Ban in some countries – China, Turkey or India have banned all the transactions with Bitcoin. Probably this ban would not have taken place if the impact in the investor community had not been so high. Sometimes, the control of the authorities can also mean the worry about an underlying bubble that may ultimately affect the whole population.

Non-bubble arguments

On the other side, there are also some elements which justify the existence of Bitcoin not only by its trading performance. With these elements, the increase in the prize of Bitcoin may be not so unfair.

  1. Increasing number of companies accepting Bitcoin as payment method – the number of companies has kept growing for the last years. In fact, some payment platforms such as Paypal accept cryptocurrencies, which is a clear sign of the value they give to them.
  2. Justification by the technical analysis – the biggest supporters of the cryptocurrencies keep finding reasons to believe in Bitcoin due to the technical analysis which the performance chart shows. This kind of argument does not make any point on the real value of the asset, but it is very considered by some kind of investors.
  3. Appearance of the institutional investors – during 2020 we have seen the stake in Bitcoin of some of the big players in the market. This means that the price does not depend anymore just on the individual sentiment, but also on the institutional investors.
  4. Impact of the halving – the halving is the reduction of the reward for mining new bitcoins, and it happens every 4 years. It implies a clear reduction on the new currency offer, which ultimately moves up the price. Some people consider this effect as artificial, as the real intrinsic value of Bitcoin remains the same.

Conclusion

In any of the examples we have not been able to truly prove the existence of a speculative bubble. It does not matter the asset, because the confirmation of the bubble comes several years after its burst. In fact, we can continuously find economists and investors claiming for bubbles in different markets. The point is not about guessing properly, but about being aware of the risks.

In the particular example of Bitcoin, the price dropped 60% during 2022. Some people would justify the existence of the bubble just because of this performance, but it is not like that. In fact, this movement of the price matches in time with the military conflict between Russia and Ukraine, two of the biggest players in the cryptocurrencies environment. Moreover, the price falls seem to have ended at a much higher level than the price some years ago.

Due to these arguments, it becomes difficult to prove the existence of a bubble even after its burst. However, we have seen that there are reasons to be careful. We will always find reasons to recognize speculative bubbles in almost any financial asset if we look for them. On the other side, we will also find reasons to discard a bubble if we have true intention of investing in that same asset.

The most important thing is to handle all the information properly in order to take the best possible decision. The classical mantra “past performance is no guarantee of future results” can be very useful. Therefore, we must invest in the assets because we trust on their intrinsic value, not because of the market trend.

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