Financial Bubbles

Is Bitcoin in a Bubble?

Disclaimer: all information provided is meant for discussion, education or opinion purposes only and is not intended as professional advice. 

Let's talk about bubbles. Clearly I have Bitcoin on my mind, and I wish I had posted this a couple days ago before this happened so I could seem like a genius. Of course you could have replied with this and told me I'm a fool. In any case, I really want to put in my two cents about these fevers and bubbles.

Speculative bubbles form all the time, and we as a society keep doing the same things over and over again and then are surprised when the floor eventually falls out. I think there's a word for that somewhere but I can't remember it...

Why do bubbles keep happening? I'm not a psychologist, sociologist or economist (I'm an accountant) but I think we need to remember one simple fact: the bubble is great if you get in early and leave before the end.

We tend to think of things in absolutes: everybody wins or everybody loses; everybody's rich or everybody's poor; etc. So when we hear talk about a bubble bursting or a company going bankrupt we tend to freak out and assume everybody lost money, that if it isn't something it's nothing and always was. The reality is that that's simply not true: the negative parts of the collapse outweigh the fortunes made in the run-up. Basically, an economic bubble is kind of like a ponzi scheme: it's great unless you're the last investor.

How Bubbles Form

Modern capitalist economics has given itself over to the invisible hand of the market, and we want to believe that this hand sets prices via cold rationality and perfect information. Unfortunately, the invisible hand is indirectly controlled by the behaviour of groups of people, and our greed, fear, passion and ignorance can create a dangerous feedback loop that causes a frenzy of demand and price increases.

This isn't a new problem, if you start typing "panic of" into google it autocompletes about 12 different dates, and that's not a complete list. I think this is pretty clear evidence that bubbles aren't going to go away, but we need to recognize when we are in one since the effects are only truly known after it ends.

Here's the core problem: value is, to a large degree, subjective. Stocks, cars, houses, gold, Bitcoin, etc., everything is worth what someone is willing to pay for it in that moment. In some cases these can be driven by some fundamental economic anchors that arrest the upward momentum of a bubble:

• Stock values are somewhat linked to performance history and stated strategic plans of a company, asking with some standard valuation methodology.
• House values will be anchored by the construction costs of building an identical house.
• Goods have a manufacturing cost and usually a competitive environment that forces competing companies to lower prices .

When we remove known information from the equation and add in emotion, it becomes the perfect breeding ground for bubbles and unreasonable pricing to form. Here's a few times where we see this happen:

• Private company valuations (the owner "feels" the business is worth more than the financial performance indicates)
• New and untested technologies and markets (.com boom, Gold rush, cryptocurrencies)
• Newly arranged financial products and proliferation of cheap lending (housing crisis, sub-prime mortgage products)

When some sexy new product, company or market starts to generate buzz and hype we need to be careful. Since it hasn't existed before, nobody knows when it will end and at what value, which then starts the following process:

1. Enter the speculators. Based on the limited knowledge at hand a price is set, often arbitrarily. 
2. As speculation and hype increases, more speculators start paying attention. This creates more demand and naturally increases the price as more people buy.
3. As the price increases, more people see the fortunes that are being made and will pay more to get a piece of it. This increases the price again, a sort of self-fulfilling prophecy.
4. After a while, all the people who jumped on the bandwagon are now owners or have gone elsewhere, so the demand goes away and everyone willing to pay the high price already own it and are looking to sell.
5. The price starts to go down as sellers can't find buyers willing to pay the current price and are forced to sell for less.
6. Owners see the price go down and start to panic and try to dump the product, rapidly decreasing the price. Again, creating a self-fulfilling prophecy as the bottom falls out.
7. At the end, some money starts to come back in and re-buy, causing an increase in the price again if the previous decrease went to low. This is the proverbial "dead cat bounce" that you sometimes see.
8. The price either stabilizes, the product goes away entirely, or the process starts over again.

It's really easy to see a bubble for what it is after step 7. The problem is that step 3 can go on for some time and is nearly impossible to predict how high it goes and how long it lasts, this won't be known until the bubble bursts. For many, it can be too late if you buy in just before step 4 happens.

You can easily see how our emotions fit into this model:

• Ignorance allows the price to grow unencumbered from a rational analysis.
• Greed makes us buy in high and stay in longer than we should, because we want it to go higher still.
• Passion drives the hype machine and entwines the purchase into our lifestyle, stopping us from making rational choices. If you catch yourself going on at length about the subject, be aware that your decisions could be clouded by passion.
• Fear keeps us from getting out when we can, because we worry about missing out on even higher price. Fear than makes us panic and sell which drives the price lower.

The Bitcoin Bubble

Make no mistake: Bitcoin is in a bubble, a scary one to my mind. I'm not saying that there isn't a huge amount of money to be made right now, and maybe more in the future, but I am expecting that there's going to start being a lot of lost money soon.

Let's consider a couple facts:

• Bitcoin is produced by fairly new technology, Blockchain, that is pretty poorly understood by the masses.
• Bitcoin has a very passionate base of enthusiasts.
• Bitcoin is unencumbered by regulation and traditional financial performance measures. This makes it really hard to predict using traditional methods.
• Bitcoin has no cash flow component (e.g. interest, dividends, etc.)

I consider most of these high risk factors for a bubble, and the sheer volatility we have seen in the market prices over the last year should confirm this in everybody's mind. As a result, I think we are at least partway through step 3, the price run-up. However, we recently saw a rapid price decrease followed by a rapid partial recovery; was this a dead cat bounce or just a short term market correction before it soars to new heights? Unfortunately, only time will tell.

So what are we seeing? A cycle of price increases driven by people hearing about how much the price is increasing, in turn causing a price increase as they buy in. This is magnified by a lot of Bitcoin holders hanging on to them so they can reap the further price increases. This, in turn, strangles supply, which increases the price faster and farther, creating more buzz and demand from the masses who assume it will keep rising. This is an interesting bubble as the very disconnect from regulations and tangibility that are its prime features makes it hard to slow down or predict where it all ends.

If you can take a long island iced tea beverage company and quadruple its value merely by changing its name and announcing an interest in pursuing a blockchain/cryptocurrency strategy, than we are long past the point where a financial anchor exists.

Just to be clear, I'm not anti-Bitcoin. I like the technology, I think the concept is great and I want those I know who are invested in it to make a pile of money! (and then hire me to count it for them) I just think it's important to not lose sight of the important fact: this is a bubble, driven by speculation and sentiment, that could fly to new heights and/or crash tomorrow. Nobody knows when or how, but I don't really question the certainty of it.

I Accept the Bubble, Now What?

This is a hard question. Where are we in the bubble? Is the sell-off coming? Is it already here? How many market corrections are left? Should I buy more?

All great questions, unfortunately the answers will only be made clear in retrospect. So let's work with what we have.

I'm hesitant to suggest you sell and get out now, mainly because I don't want to be blamed if the price increases further. Human nature is such that, if you bought Bitcoin at $1,000, and it's worth $15,000 now and you sell, and next week it's worth $30,000, are you going to be happy with the $14,000 you made or angry that you "lost" $15,000? For most of us (myself included), probably the latter. 

Please remember, until you sell and take the profit, you haven't made anything. I hear a lot of people talking about how much money they are making with the price increases, but unless they cash out the gains they've made nothing. When you get obsessed with the price, it becomes really hard to act when the price starts to drop because you feel that you need to wait until you "make your money back". I once knew someone who bought a house for $200,000, the market price grew to $500,000, but then dropped to $400,000. He hung onto that place for years longer than he should have because he felt like he lost $100,000 instead of made $200,000 and it cost him way more in stress, mortgage cost and property taxes while he waited for the price to go back to $500,000 (note: it never did).

If I had to recommend anything, it would be to take some or all of the profit, cash out and know you've made a killing. If you feel that it might not be the end, that we are not yet in steps 4 and 5, buy back in with some of your profit so you still reap the increases. If it collapses, you only lose your risk cash. If it keeps going up you're still participating but your risk profile has lowered. If you can't predict when the market correction or collapse will happen, you have to hedge your bets or risk losing everything. 

Market speculation is just a form of gambling and leaving your investment in place over a long period is the equivalent of playing roulette and betting on black all the time. Thing is, if you cash out from the table and walk away you don't know what the next spins would be, so you are secure in your decision. Investments suffer because, if you cash out, you can easily check and see if you would have won more if you stayed in longer, so regret is easy to find and our fears feed on that possibility.

Also, remember to pay your taxes. Just because this is something new doesn't mean it's tax-free.

Author: Michael Glazier is a Chartered Professional Accountant and legacy Chartered Accountant providing a range of accounting and tax services to his local Winnipeg area and remotely to clients across Canada. He has over 12 years of experience in personal income tax, corporate income tax, assurance and various specializations and experience in accounting and tax issues around R & D, investments, projections, valuations and paperless transition. You can find out more by visiting the Glazier CPA website or by emailing at mglazier@glaziercpa.ca.