Millionaires in the Making
Bitcoin (BTC) recently set a record for fastest documented rise of a widely traded asset in recent history. Just over the past year and a half, the BTC currency has soared over 6,000%. The second fastest recorded price accumulation in history is the Gouda Tulip Bubble of 1934 to 1937, which escalated 5,800% over a similar time horizon. If we take a further step backward in time for perspective, the BTC currency has inflated nearly 29,500,000% since its nickel valuation in 2010.
With BTC gains so easy to come by, the difficulty now lies in whether to jump in and strike while the irons hot. Having read the recent stories of BTC turning teenagers into multi-millionaires and guys travelling the world with their BTC earnings makes it seem that dreams of striking it rich are within reach of anyone. However, before we mortgage the house on BTC, let’s take a random walk through history and visit the 5 largest bubbles ever recorded and see what lessons we can learn from each. After all, history has a propensity to repeat itself.
Image Source: Multiple data sources organized in Excel by Author
lesson #1 – Check for intrinsic value
History has been filled with bubbles sporadically inflating and bursting across many asset types. Whenever you gather a group of speculative traders in a free market with wants, needs, and desires, you are bound to discover a bubble at some point in time. The following traded item, however, has to be one of the most random of any speculative “asset” in recorded history.
In 1593 the tulip bulb landed in Dutch soil after a long journey from Turkey. These tulips quickly gained popularity for their vibrant solid colors, but soon caught a virus in their new environment. This caused the pedals of the flower to burst into various flaming colors. Demand for their new beauty rocketed and prices soared above already premium stature as everyone began dealing in bulb futures. The sky was the limit and speculation spread wilder than the tulip’s pedals. Actual bulb buyers soon began stocking up on inventories for their garden centers, cutting supply and increasing scarcity. Prices rocketed further as bulb contract buyers saturated bulb supply. For every buyer, there was an anxious seller waiting to push the market prices higher. Speculative traders anticipating future buyers to continue playing began exchanging land, life savings, and anything they could liquidate to capitalize on the rise in price.
Image Source: Was the Tulip Bubble Really a Bubble
Before long, the market outran its legs. The asking price for a simple plant far exceeded its “true” value, if its true value ever existed, and the majority of the population could no longer afford to buy bulb contracts. Like most other bubbles that followed, it only took a handful of prudent investors to sell their stock for profit and puncture a hole in the euphoria. Prices dipped. A cascade effect ensued where the market was flooded with sellers trying to get out before prices fell further. The rubber band snapped and prices crashed with buyers no longer willing to burden the risk.
The government soon stepped in, honoring contracts for 10% of face value to help absorb the shock of life savings and property lost over a handful of worthless tulip bulbs. It was too late. The entire market fell into an economic depression that lasted for years after. It turns out, a small plant or bulb has no intrinsic value compared to land or a roof over your head.
South Sea company
Rule #2 – Avoid chasing returns before knowing the facts
There’s smart money and there’s abundant money. The issue with an abundant supply of money is that investments in marginal risk assets become saturated and inflated. Foreseeing lower future returns from already inflated prices, the remaining money seeks high risk assets in pursuit of alpha. This can result in trade schemes and poorly informed decisions with the remaining money.
During the 1700’s, the British Empire literally ruled the world. For the British, money was abundant and prosperity rampant. This meant the Brits had money to invest, but quickly found few outlets to park their cash. Most companies offered shares to a limited and elite pool of investors, so much of the population was left in pursuit of alternatives. The famous East India Company, for example, paid out considerable tax-dividends only to lucky investors privileged to own shares; all 499 of them. Enter the South Sea Company and their IPO to the public after striking a deal for exclusive trading rights in the South Sea.
In exchange for monopolistic trade with Spain in South America and the West Indies (“the South Seas”), the South Sea Company (SSC) purchased Britain’s war debt. Investors flocked to the newly available shares and the speculative riches to be made from the potential gold and silver trade in this region. The company issued more stock. The price jumped. The company issued stock again. Investors from all classes continued to flock in pursuit of places to park their newly earned wealth. Throughout Britain, IPO’s began to sprout from every direction in an effort to feed the hungry investor crowd, including companies promising to reclaim sunshine from vegetables and to build floating mansions along Britain’s coastline. So began a frenzy for investment for the sake of investment. Until the facts caught up to the speculation.
It turns out the SSC and many of the other recently public companies were run by inexperienced and inept management teams. Whole shipments of wool were misdirected and rotting in foreign ports. SSC management specifically failed to turn a profit and the Mexicans and South Americans weren’t as anxious to trade wool for gold as anticipated. Seeing a disconnect between the market’s price and the true value of the company, management sold their positions in the summer of 1720. It wasn’t long before word leaked, and panic selling ensued and burst into the rest of the overbought market. Even the ever brilliant Sir Isaac Newton could not escape the hype and ensuing pain of a bubble popped, losing three million pounds in today’s currency.
Image Source: How Not to Invest Like Sir Isaac Newton
Rule #3 – Never bet the house
The risky aspect of buying on the margin is that lenders expect you to cover losses on your portfolio. This means market crashes have the double effect of chopping into your portfolio’s value and forcing you to pay back your losses plus interest. If we were to consult the great Warren Buffett’s rules for successful investing, rule number one would blatantly command that we never lose money. Rule number two would remind us to never forget rule number one. Regardless of confidence in any market or investment, it should always be remembered that losses can happen at any time, for any reason, and to never bet more than you are willing to lose.
The nation’s wealth doubled during the 1920’s as stocks and margin lending rocketed. Margin buying was marketed down to the smallest of investors looking to dive into the ever-rising market. All it took was as little as 10% down with 15% interest on the remainder of their loans to strike it rich. Buying on margin was the "bee’s knees" and everyone was getting involved. Trading on inside information was legal and rampant. Prices spiked and dropped from big money collusion, but the market kept rising. Losing no longer seemed an option.
For the first time, a majority of the Country was also enjoying the luxuries of city life and party culture of the roaring twenties. The mood across the country was perfectly captured by President Herbert Hoover’s after winning the Republican Nomination:
Toward the end of 1929, margin debt had swelled to 12% of GDP, or $2T dollar in today’s economy compared to $450B margin debt at present. Buying leverage began to max out as buyers started running out of capital. Prices swooned. The first crash occurred on October 24, 1929, dropping the market 13%. Daily losses followed throughout the next two months. As market prices dropped, money owed on margin exceeded the residual value of portfolios. Before confidence could be restored, the market had crashed 90% and significant fortunes were lost.
Banks raids and lack of Federal Deposit Insurance sent nine thousand banks to their graves over the subsequent nine months. The whole country seemed to unravel while an economic depression crippled any chance of recovery. Within two years of Hoover’s exclamation, the party had been completely hijacked by gripping poverty across the nation.
Nearly everyone was caught with their pants down while cash was sucked out of the system. The tower of cards propped up by leverage and dreams had collapse and it would take more than a decade for the economy to recover. By 1940, the country still had a 15% unemployment rate.
Rule #4 – Stick to fundamentals and don’t be afraid of missing out
The year is 1995. We have finally arrived at the start of the first bubble that most seasoned investors can personally recall – the tech bubble or Dotcom bubble. The age of the internet had just matured from its infancy and was entering into its awkward teen years, in the early stages of discovering itself. Beginning in 1995, a handful of high-tech giants were growing the NASDAQs foundation while upstart companies were just starting to fuel a surge in speculation. Easy capital and cheap money had also just entered the market, accompanied by extreme confidence in the economy.
Investors and venture capitalists, hoping these upstarts would eventually turn a profit, abandoned all caution and traditional valuation methods in pursuit of castles in the sky. As prices in tech accelerated upward, a feeding frenzy began on any new company with “.com” at the end of its name. A fear of missing out on gains was exacerbated by the sense that everyone and their neighbors was profiting immensely in the stock market. It seemed that only the suckers were missing out.
Heading into early 2000 as a final hoorah, the NASDAQ nearly doubled. Shortly after and unbeknownst to the general public, giants Dell and Cisco placed huge sell orders on their stocks. The NASDAQ market lurched to a stop and reversed. Then investment capital, the fuel that was sustaining all of those unprofitable startups, dried up. Without this capital lifeline, companies began to burn cash reserves into bankruptcy. By the end of 2001, a majority of publicly traded dot com companies had closed shop, evaporating trillions of dollars in investment capital with them.
Housing and Credit Bubble
Rule #5 – Understand the fundamentals driving the market
Not all capital was lost during the tech bubble’s implosion. Starting in 2002, a significant amount of money removed from the tech bubble began flowing into the more stable housing market. Investors were looking for a safer place to park their cash after the wild dotcom ride. Like the tech bubble, prices began to rise in real estate and a new excitement began to spread. Over the next six years, real estate prices nearly doubled in a market known for 6.4% annual growth, as speculation on future prices again began to grow roots in another asset.
Historically, mortgage lending policies coupled with healthy mortgage rates would have filtered out any risky and speculative borrowers. However, easier lending policies and record low mortgage rates crumbled what had historically been barriers to entry for new homeowners. Home ownership jumped to a never before seen 69% of Americans into 2004. Again, the sky became the limit on pricing and buyers willing to pay more were a dime a dozen.
Image Source: Home Ownership in the United States
For years, loose policy and favorable lending conditions opened the doors for a buildup of subprime mortgages with adjustable rates that saturated the market. An estimated 56% of home purchases during this period were made by people who would not have been able to afford their mortgages under normal lending requirements. As rates began to rise with inflation and the economy, the once affordable loans became more expensive. Defaults began to accelerate and quickly unraveled the inflated market.
Eventually it would surface that subprime mortgages were being packaged with low risk mortgages and sold off to unknowing investors. The market, in essence, had been accumulated hidden risk.
Image Source: Orange County Housing Bubble 2.0
How Does This Relate to Bitcoin
Nearly 10 years later and we have reached a new hysteria in an asset class: Cryptocurrency and its fearless leader, Bitcoin.
Bitcoin has four aspects that feed its value - scarcity, utility, supply, and demand. Only 16.2M BTC currently exist, with an intentional cap of 21M. The currency has also gained utility in recent years as more organizations and users recognize and transact with the cryptocurrency. Finally, supply and demand by miners and traders have largely governed its price and created its recent explosion in value. These economic essentials also hold true for established currencies and gold.
The hope and dream is that Bitcoin will eventually force the financial system to fundamentally reconstruct with BTC leading the way as the dominant decentralized and universal currency. To BTC's credit, no single person or entity currently controls BTC so the movement has largely been organic. Therefore, its meteoric rise deserves due respect, especially for a concept designed to operate as a game (this truly is a remarkable read).
Where the recent BTC movement starts to get concerning as an investor is in comparing it to the characteristics of our historic bubbles. Just like tulips, BTC holds no intrinsic value, nor is there a central authority to step in and regulate prices should things go awry. This leaves the price and direction of BTC up to a million ghosts making transactions in the shadows. Who will prop up the market should the price and whole system built on trust begin to collapse? Certainly not the government as gold and the dollar alteady make for sound barter. What about the current traders of the currency?
Knowing who trades BTC is somewhat tricky. Direct BTC trades are nearly impossible to monitor because of their intended anonymity. Fortunately, new index exchanges like CoinDesk track their user’s profiles and shed light on BTC demographics. This data along with survey information can help us construct our picture on the type of investor in BTC.
Image Source: Bitcoin Users - Who They are and What They Do
Nearly 40% of Bitcoin users are young adults (age 25 to 34). This means 4 our of 10 traders have likely not experienced a major asset correction in their investing careers. For the past decade, it has been easy to throw money around and watch it grow. Its this persona and reckless abandon that tends to rush into speculative assets in persuit of alpha just as quickly as it runs at any sign of weakness. Just like every bubble prior, let the good times roll, until the lights flicker and its everyone for themselves to the exits.
To give BTC credit, its early investor have experienced one major correction in BTC's young history, plummeting from around $1,100 to near $200. This occurred in 2013 thru 2014 when volumes and interest were significantly lower than they are today. Unfortunately, this appear to have only been a very small set of BTC users relative to the new capital flooding into the currency today.
Image Source: Google Finance
The other concern relates the other 1,036 cryptocurrencies currently trading in the market. Just like Britain's IPO's in the 18th century, it seems everyone wants a piece of this currency hungry market. It also only took one bad apple (Southern Sea Co.) to burst confidence in the market and reveal wide scale weaknesses. With all of these new guests at the party, it may only take one scam to sound the fire alarm and send everyone running.
Let's also investigate capital, the driver and deflater of the great recession. Trade volumes in BTC recently exceeded $5T dollars, of which 53% originated form the Americas. To understand this scale, the $2.5T of transactions in the Americans is equivalent to 12% of total GDP of the Americas. Where will this money continue to originate from and is it sustainable?
For those long BTC, hope lies in wider adoption and use, which will justify its value (recall out economics 101 discussion on utility and demand). However, with BTC futures now trading on most exchanges, many of the recent interest and entrants have originated from speculators and short term profit seekers, not long term utility drivers. As we learned from the Great Depression, this growth from investment capital is not sustainable and even margin lending has its limits before all buying power is exhausted.
Hype Curve and DotComs
Another concern for speculative investors in BTC are Gartner's hype curve diagrams from 2015 and 2016. Gartner provides a great graphic below on various new technologys' locations on the hype curve. As of 2016, block chain (BTC) received a notable mention, having nearly reached the summit of its hype. A year prior in 2015, Gartner also located cryptocurrencies toward the end of inflated expectation.
When we look at the hype curve, it holds eerie similarities to the shape of the NASDAQ market between 1995 and 2002. Hype over speculative startups accelerated into peak inflated expectations, before the market collapsed into a trough of disillusionment. Fundamental growth stocks like Cisco, Intel, and Microsoft eventually carried the market higher, but not after a painful correction from the highs in early 2000. For a BTC currency that has potentially peaked in expectations, I’d be concerned with an impending reality check on expectations.
Finally, its hard to put a finger on what specific fundamentals are driving this cryptocurrency market (hopefully someone can share their thoughts in the comments). Maybe its just the hysteria of seeing prices jump and the market having the money available to slosh toward castles in the sky. Regardless, I still live too close to the Housing Bubble to want to jump into a concept which has fundamental driving forces that I don’t fully understand.
This article is not a warning or short on BTC, but a “beware”. If history’s voice can be heard, it would likely want to remind us that this situation could get ugly fast. Just remember the five rules from our ghosts of recessions past. If you can answer them with confidence and feel comfortable with the risk, BTC may be just for you. Personally, an 8% historic market return over 30 years (10x growth) in the general market sounds plenty appealing to me.
- Check for intrinsic value
- Avoid chasing returns before knowing the facts
- Never bet the house
- Stick to fundamentals and don’t be afraid of missing out
- Understand the fundamentals driving the market
Alternative BTC Play
No one wants to be caught exposed at the tail end of a bubble, but even the most intelligent like Isaac Newton are susceptible to moments of greed. For an alternative way to play this Bitcoin frenzy regardless of which way the BTC price moves, consider this low risk "pick and shovel play" discussed here.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.