On Investments

Bitcoin price breaks $10,000. Here's what history tells us comes next.

Loosely defined, a bubble is a rapid increase in an asset price that's not substantiated by its fundamentals

Nov 29, 2017 @ 5:00 pm

By John Waggoner

Some investors have raised the question: "Is bitcoin a bubble?" This is somewhat like asking whether Taylor Swift makes records, or Kim Jong Un likes rockets. But let's look over the evidence.

Economists have long held that investors are rational people who act in enlightened self-interest. History suggests economists should get out more. Financial manias and bubbles are a feature of economic history: Financial bubbles include the Dutch tulip bubble in 1636, canal and railroad manias in the U.S. and Britain in the 1830s, and stock manias in the 1920s and 1990s, just to name a few. On a lesser scale, manias have erupted around Merino sheep, mulberries, baseball cards and Beanie Babies.

Loosely defined, a bubble is a rapid increase in an asset price that's not substantiated by its fundamentals. The unfortunate part of this definition is that this is best seen in hindsight. There are always reasonable-sounding people who offer convincing arguments that an asset's price in a bubble is perfectly reasonable.

Internet stocks in the 1990s, for example, were based on reality: Personal computers and the internet would revolutionize the way people interact and do business. Unfortunately, enthusiasm for internet stocks far outpaced their earnings, which were often nonexistent. The ensuing collapse was the second-worst bear market since the Great Depression — at least until the housing bubble of 2006 popped.

Bitcoin proponents tout the security of the blockchain, which is true, and the viability of cryptocurrency as a substitute for the dollar, which is dubious at best. Most people prefer currencies with relatively stable value, as Nobel Prize-winning economist Richard Thaler pointed out this fall. A country that used bitcoin for its currency would be in the throes of massive inflation today.

Manias have other touchstones, which bitcoin seems to touch fairly well:

Rapid price increases. During the 1980 gold bubble, the price of the yellow metal soared from $559.50 on January 2, 1980, to $850 an ounce on January 21. In comparison with bitcoin, the gold mania was a piker. Bitcoin hit $11,343 Wednesday, according to coindesk.com, blowing through the $10,000 level early in the morning before falling through the day and hitting $9,926 as of the publication of this column. The cryptocurrency began the year at $968.

Derivatives. The rapid rise in an object's price usually results in the emergence of ways to amplify your bets. During the tulip mania, traders developed primitive forward options trading, so they could trade bulbs outside the planting season. LedgerX, an institutional trading platform, began trading bitcoin options last month, and the CBOE and the Chicago Mercantile Exchange are planning bitcoin options.

Funds. In the 1920s, Wall Street created funds of funds that amplified stock gains. (These prototype triple-leveraged funds are now outlawed). The success of Bitcoin Investment Trust (GBTC), which often sells for a premium of 40% or more above the value of its bitcoin holdings, has spurred filings for several other applications with the Securities and Exchange Commission to sell bitcoin ETFs to the public. ProShares filed for two funds — one bull and one bear — in September. VanEck and the Winklevoss twins have filed for bitcoin ETFs, but were rebuffed by the SEC. The creation of bitcoin futures, however, could clear the way for future bitcoin ETFs.

Competition. One thing that drives prices up is rarity. Bitcoins are limited to a total issuance of about 21 million coins. But there are some 100 other cryptocurrencies available. Some of them, like Centra Token, have garnered endorsements from celebrities such as boxer Floyd Mayweather and rapper DJ Kahled. Centra's initial coin offering raised $30 million.

Here's where learning from the Merino sheep mania of 1802 comes in handy. The sheep were introduced to Vermont that year at the time when U.S. trade relations with Britain, a major wool producer, were poor, to say the least. Wool prices soared, Vermont sheep raisers got rich, and by the late 1830s, there were more than a million sheep in Vermont. But Merino boosters in Vermont forgot that other states were capable of raising sheep as well, and eventually wool prices collapsed.

Frauds and swindles. These usually come to light once the bubble pops. The SEC issued a warning to the public not to invest in initial coin offerings. "Investing in an ICO may limit your recovery in the event of fraud or theft. While you may have rights under the federal securities laws, your ability to recover may be significantly limited," the SEC said. The agency has already charged one Texas man, Trendon T. Shavers, with operating a bitcoin Ponzi scheme.

Why bubbles emerge is a matter of debate among economists, although loose credit conditions seems to be one common denominator. Another seems to be a general atmosphere of euphoria — animal spirits. (Not surprisingly, stock market bubbles often coincide with the creation of tall buildings: The Empire State building was started in 1929, and the third-largest building on the planet, the Shanghai World Financial Center, was completed in 2009.)

The other problem with bubbles, of course, is that they're lots of fun until they pop. When the Florida land boom ended in 1927, startled farmers discovered that the daisy chain of bankruptcies left them with ownership of land they thought they had sold years earlier. The 1929 stock market bubble ended with the Dow Jones Industrial Average posting an 89% loss.

Stocks, at least in theory, have some underlying value, as does real estate, gold and even tulip bulbs. It's hard to imagine a practical reason for owning bitcoin, aside from trading or hiding criminal activity. As Josh Brown, CEO of Ritholtz Wealth Management noted recently, bitcoin has fallen by 80% or more on five separate occasions. It could happen again any time.

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