Bitcoin: How You Can Spot A Bubble

As I write this, it’s currently mid-March 2019 and a thought just randomly popped into my head. Bitcoin. What happened to it? Maybe more importantly, why is nobody talking about it? 

The answer, really, is quite simple. And there’s an easy way to prove that this answer is true. Have a look at the graphs below. 

Bitcoin USD Price vs Google Trends for Bitcoin - Searches During The Bitcoin Bubble

The graph on the top is the price of 1 Bitcoin in US dollars. The bottom graph is Google Trends data for the term “Bitcoin”, worldwide. All data from between the 1st of January 2017 and the 1st of January 2019.

It doesn’t take a genius to spot that both of these graphs have a similar shape to them. A slow upward trend towards late 2017, followed by a large spike, a sudden drop and a general gradual decline ever since. 

Google searches for the term ‘Bitcoin’ spiked on 2 separate days in December 2017. December 7th and December 22nd. On December 7th, Bitcoin’s price hit an early December high of nearly $17,000 and by the 17th, as more people piled in, Bitcoin was valued at nearly $20,000.

But, the trend was short lived. From the 18th to the 22nd, Bitcoin’s value fell by nearly $7000 to just over $13,600. And it was on that latter date that Google searches for the term ‘Bitcoin’ hit its all time high.  

The Bitcoin Bubble and The Crash

The news cycle can be short. Trends take hold and then, before you know it, something else has taken the spotlight. Bitcoin didn’t suddenly skyrocket in price due to a sea-change in consumer cryptocurrency confidence. The price increase was driven by the price increase.

Commodity prices are driven by a number of factors. But the price of a commodity can be a hugely influential factor in itself. And herein lies the problem.

Bitcoin’s price was driven up as more people bought into it. And a large swathe of people that bought into it did so in order to sell it to someone at a higher price. People saw the gains that others were making and they jumped into the ship for fear of missing out (FOMO). This drove up Bitcoin’s value further making it more appealing to speculators. 

Of course, here is where we run into another problem. As the price rocketed in value, people became hesitant of realising their gains. Why sell at $19,000, when tomorrow the price could hit $20,000?  

Here’s where we come to, the crash. Short term price speculators (asset renters, not buyers) don’t have confidence in the underlying asset, their confidence lies in the price. So when the gains shrink or when gains become losses, the confidence vanishes. And they jump off of the ship just as quickly as they jumped on. 

Some make money, some hang on to recoup their paper losses and some just lose. 

Historic Comparisons - Tulip Mania

Generally considered to be the world’s first recorded speculative bubble, ‘Tulip Mania’ (Tulpenmanie in Dutch) was the term coined for a phenomenon which occurred in early 17th century Holland. 

Tulip Mania in Holland - Tulpenmanie - comparisons with Bitcoin

Tulips, the vividly coloured flowers, were introduced into the European market in the mid-1500s. The flower grew in popularity so quickly that demand for tulip bulbs eventually exceeded supply. Prices followed this increase in demand to the point where rarer tulip varieties became symbols of wealth and luxury.

In 1636, the Dutch formally recognised a futures market where people could purchase contracts on tulip bulbs before they were even harvested out of the ground. Traders would buy and sell these futures contracts, thus pushing up tulip prices even further. 

Rising prices attracted poor and middle class tulip speculators. There were cases of people mortgaging their estates and their businesses to buy bulbs for the purpose of selling them on at even higher prices. 

Trading hit its breaking point in early 1637 and over the course of a few days, prices tumbled. Confidence evaporated, fortunes were lost and tulip mania was now a thing of the past.   

The Internet Fuels Bubbles

It’s almost impossible not to see the comparisons between Tulip Mania in the mid-17th century and Bitcoin in the 2010’s. But there is one major contextual difference between then and now. Technology. 

Information now spreads rapidly and with ease across the world. There are huge advantages that come with that. We are more connected now than we have ever been. 

But it’s important to remember that global connectivity heightens the risk of hysteria. And this can fuel a commodity bubble. 

How To Spot A Speculative Bubble

First off, if it’s trending on Twitter, chances are hysteria is at its peak. Google Trends, similarly, allows you to view, in near real-time, search trends in individual countries and across the globe. 

It’s a good measure of how much the world is caring about something, at any particular point in time. In this way, it’s quite a good accessible tool which allows you to measure how much fuel is being put into a commodity bubble’s fire. 

Secondly, ask yourself why others are buying into it? Are they likely to be asset renters or asset buyers? Asset renters want to make money quickly. They want to buy something to sell to someone else at a higher price. They might not care about or have any knowledge of the asset that they’re holding. 

Asset buyers, on the other hand, trust the asset they’re buying into. If it’s a stock, they’re buying a company that they trust to produce profits and therefore returns. If it’s a fund, they trust that those companies, collectively, produce profits and returns overall. If it’s a government or corporate bond, they’re trusting that they will be paid interest on that loan. 

If the price increases sharply over a short space of time, what’s changed? Do people, for whatever reason, have greater confidence in the asset’s ability to produce returns. This might occur if a business releases a positive quarterly report. Or are they simply riding the price wave as it goes up? Is it likely those ‘investors’ are simply experiencing fear of missing out (FOMO) and they’re ‘investing’ because they feel pressured to do so. 

Asset buyers buy the business, asset renters buy the price.  

“It’s the business I look at, when you’re just looking at the price of something, you’re not investing” - Warren Buffett

What A Bubble Tends To Look Like - Stages

Hyman Minsky, the American-born economist, developed the ‘Theory of Financial Instability’ and identified the five stages of a bubble. This theory garnered a lot of attention in the wake of the 2007/08 subprime mortgage crisis. He wrote extensively about the subject in his book, “Stabalizing an Unstable Economy” which he published in 1986.

Stage 1: Displacement 

When investors become excited about a new disruptive paradigm. For example, the excitement around the creation of cryptocurrency. 

Stage 2: Boom

In-line with this wave of investor excitement, the narrative becomes incredibly convincing and prices start to rise. As more and more people buy into the asset, prices rise even further.

Stage 3: Euphoria 

Fear of missing out sets in. Other potential investors are seeing these price rises and they buy-in too. Investors justify price increases by stating asset prices are still undervalued. There’s a failure to acknowledge that the price increase is likely caused by the price increase itself. 

Stage 4: Crisis

Short term asset renters heed warning signs of a bubble and begin to lock-in profit, for fear of a larger crash. Selling decreases asset prices, fuelling further panic-selling. The bubble has been burst. 

Stage 5: Revulsion 

Before, the asset was overvalued, it now goes in the opposite direction. Prices fall below fundamentals, investors steer well-clear

Conclusion

I, myself am a long term investor, invested in diversified stock index funds. I never invested in Bitcoin and I don’t plan to in future. However, I think there’s an important distinction to be made here, which is why I chose my words (re: “invested”) very carefully. 

Bitcoin, and the underlying blockchain technology, could (and is) changing the currency landscape. I may, in future, purchase Bitcoin, or another alternative, to use transactionally. I can’t predict if it will ever make sense to do so. 

But buying Bitcoin to transact and buying into Bitcoin as an investment are two very different things. 

I can’t predict the future of cryptocurrency but I do know there are lessons to be learned from the past. If an investment becomes a twitter trend, be mindful and be skeptical. Don’t succumb to fear of missing out, go against the grain and invest your money wisely.

What are your thoughts on cryptocurrency and speculative bubbles? Let me know in the comments down below.