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Bitcoin Meets Every Criteria Of A Bubble


We judge Bitcoin to be a “bubble” using the framework devised by Economist Robin Greenwood.

Bitcoin exhibits major historic “symptoms” of bubbles in the equity market.

•We expect bitcoin to experience at least at 40% drawdown over the next 12 months.

When we claim that Bitcoin is in a bubble, we don’t claim to be presenting anything you don’t already know: according to the CNBC Global CFO Survey, 28% of surveyed investors think that Bitcoin is in a bubble, and another 28% see it as a fraud. Instead, we attempt to analyze Bitcoin through an academic framework, using the 2016 working paper “Bubbles for Fama” by Robin Greenwood.

Greenwood defines a bubble as a 100% or greater price run-up over a 2-year period. Of course, this degree of appreciation does not automatically make something a bubble—plenty of assets have seen this price run-up and never “popped”, like Apple between 2013 and 2015. Greenwood analyzes all sector-level US equity price run-ups during the 20th century and identifies several factors that distinguish between assets that “crash”, as defined by a 40% drawdown at some point over the next two years, and those that don’t.  The factors present for bubbles are:

  • New issuance: sectors in a bubble tend to experience a large number of IPOs
  • Divergence: new firms sharply outperform older firms when a sector experiences a bubble

Evaluating Bitcoin under this framework, Bitcoin clearly fits these criteria of a bubble.

Price Run-Up: As of January 16, 2018, the cryptocurrency has shown a 1,227% increase over the last year and a 3,003% increase over the past two years. During the month of December, Bitcoin surged to an all-time high (at the time of this writing) of more than $19,000. This easily surpasses the threshold of a 100% increase over a two year period.

Greenwood notes a relationship between size of price run-up and probability of a crash. At a 50% price run-up, net of market returns, the probability of a crash is 19%; at a 100% price run-up, the probability of a crash rises to 54%. When the threshold is raised to a 150% price run-up, the probability of a crash increases to 80%. If this relationship holds at larger and larger price run-ups, the statistical probability of a crash given a 1000%+ price run-up like Bitcoin has experienced is incredibly high.

New Issuance: New issuance has been rampant in the cryptocurrency space. In 2013-14, only 3 major ICOs occurred; in 2016, at least 24 cryptocurrencies were issued, and in 2017 36 cryptocurrencies have already been issued in an ICO as of October. Greenwood posits that new issuance is rampant in market bubbles simply due to supply and demand: the capital markets demand these assets, and entrepreneurs are eager to supply them while prices are high.

Divergence in Returns: Greenwood also presented the divergence in returns between old and new firms as an indicator of a potential bubble. While bitcoin lacks “older” cryptocurrencies against which to compare it, we will use gold as a proxy for “older” assets. Gold is an asset that exhibits many of the same characteristics as Bitcoin—limited supply, no underlying cash flows, and consideration as a currency despite not having government backing. By comparing the returns of bitcoin and gold over the past two years, it is evident that Bitcoin has exhibited a vastly different pattern of returns. This divergence fits the model’s criteria of a bubble.

                When examined through Greenwood’s “Bubbles for Fama” paper, Bitcoin tends to fit all the major indicators of a bubble. It has experienced an incredible price run-up of more than 1,000% over the last two years, easily meeting Greenwood’s criteria for a “bubble”. New issuance has soared, with at least 36 major cryptocurrencies “going public” through ICOs in 2017. Bitcoin has diverged from older currencies and gold, with little to no correlation over the past two years.

                So when will the bubble pop? That’s what everyone wants to know, and we do not claim to have an answer. If we had to speculate, we would guess that regulatory moves by the US, EU, and/or China will cause the first major sell-off. Rising interest rates in the US also make Bitcoin less attractive vis-à-vis cash-flowing assets. While we can’t give you the date that Bitcoin will crash, we fully expect at least a 40% drawdown in Bitcoin to occur over the next two years.

Sources: Greenwood, Robin M. and Shleifer, Andrei and You, Yang, “Bubbles for Fama” (February 2017). NBER Working Paper No. w23191. Available at NBER: Bubbles for Fama.

Volastro, Anthony, “US finance leaders are least likely to embrace bitcoin, and some see a fraud: CFO survey”, CNBC, November 30, 2017. US finance leaders are least likely to embrace bitcoin, and some see a fraud.

Disclosure: We have no positions in any assets mentioned, and no plans to initiate any positions within the next 72 hours.

We wrote this article our, and it expresses our own opinions. We are not receiving compensation for it. We have no business relationship with any company whose stock or cryptocurrency is mentioned in this article.

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