Are Cryptocurrencies on a similar path as the Internet in 1999?

Opinions on bitcoin and cryptocurrencies usually are very binary:
  • cryptocurrencies are about to take over the world and the sky is the limit for valuations (sometimes with a caveat about nonsensical ICOs)
  • cryptocurrencies are a fad and what we are seeing is the greatest bubble since internet stocks in the late 1990s
Often smarter commentators acknowledge that they don´t know which one of the above it will turn out to be – in fact, I think, nobody can possibly know.


 

Listening to these opinions from an investor´s perspective, I think there might be a fair chance, that both extremes will turn out to be right temporarily.
It is easily possible that cryptocurrencies´ path will simply not progress in a straight line up or down (few things do). Just as internet pundits were right with their claim, that the technology would change the world – and little good did that truth do for most investors in 2000.
Is it likely that cryptocurrencies can take a similar path as internet stocks? If so, we might draw some interesting conclusions for smart investing.


 

Many hyped investments with a solid core idea froth up initially, with more and more unsustainable business ideas being financed by the bubbly sentiment and asset prices inflating. This happens again and again, though rarely on the scale of internet companies or tulip bulbs.
In cryptocurrencies´ case many ICOs with rarely a hope to gain traction and sufficient real world implementation to be sustainable (or that are even outright scams) get money thrown after them. I think, most experts agree that this is the case right now.
At some point no more greater fools are willing to support these ideas and the house of cards comes crashing down. This will impact solid ICOs as well as the valuation of the core technology represented by the price of bitcoin – even if that technology will turn out to be a game changer in the end.
When that point is reached (not so much if) and how far the fall is going to be are the big questions. Virtually all great speculative ideas (e.g. FANG stocks) have had drawdowns of more than 50% in the course of being a great success story. So let´s define a drawdown of 50% or more for the price of bitcoin as a major fall and a point where investors become seriously worried.


 

In the next phase, that might take a rather long time, the strong ideas are separated from the weak (who disappear), new superior players are created and these begin their ascent connected to the real world impact of internet (or blockchain) technology. This is what happened to the FANG stocks – but it did take 10 years for an exceptionally strong survivor like Amazon to reach the 1999 highs again and more than 16 years for Nasdaq as a whole. Many of todays biggest players did not exist in the 1990s nor did they make a straight ascent to where they are now even without being part of the 2000 crash.


 

How can we use that analogy to our advantage?


 

Cryptocurrencies are, without a doubt, the hype of the day. They could be poised for a crash and be a game changing new technology at the same time.
Conclusions:
  1. If analysis is right and a high percentage of ICOs are unsustainable ventures (less than 10% of ICOs are judged sustainable by different experts in the field), that house of cards is bound to come crashing down sooner or later – a fall for bitcoin of more than 50% is very likely. When is that going to happen? Unfortunately that´s unpredictable. Speculating on getting that point right is a gamble – at best with probabilities in your favor.
  2. To me the analogy lies not so much in the question whether cryptocurrencies will crash considerably, but more in the question of what happens after such a major drawdown – will blockchain technology become true world changing technology? Alternative future paths would be solid smaller scale application for blockchain (analogous to 3D printing for instance – another recent hype) or it may fade into oblivion.
  3. The more severe the crash, the longer the recovery phase is likely to be.
  4. Not only is blockchain an entirely new technology, but cryptocurrencies are essentially a new asset class. There exist few structures for larger investors to invest in it yet. A lot of potential money is still on the sidelines as these structures are being created, hedge funds founded, investment committees convinced, etc.. The turning point may therefore be a long way away.


 

The main problem from an investor´s perspective is: How to invest when a hype has been hot for some time and there are already uncommonly large gains on the table? How to trade it when excessive sentiment is clearly developing and your not in? Do you jump in to ride it up, try to short it down or ignore it?
As we want to invest in a systematic fashion, it won´t do to simply jump in, hope and get out at an undefined point. How could we define our investment process more clearly?


We will not be able to predict the turning point, but could use a long term trend-following method to catch a large portion of the ride up and be stopped out on the way down. Success ultimately depends on how far from the top we are at our entry point – or, going back to our analogy, how far along in the Internet´s 1990s development are we right now with cryptocurrencies?
It is unlikely that we will manage to time the exact top with our entry, but not impossible. After all the highest investor money inflows into stocks where at the beginning of 2000 – many people managed to time the top perfectly, just not the right way around.
If we would use a simple moving average rule to invest (buy bitcoin because the possibilities feel so infinite, exit when price drops below the 200-day moving average), the high dynamic and volatility of bitcoin implies, that price has already moved a long distance away from the moving average we use to get us out. The problem we have is, that we are not entering when a trend system gives us a viable signal (which would have been in 2015), but that it is already much later.
In the case of the Nasdaq its price had to drop about 35% in 2000 before an exit was triggered – a large part of profits to give back, but better than losing roughly 80% from the top. Still we had to have entered about 5 months before the high to barely escape with the tiniest of profits (not to mention the agony of seeing paper profits of almost 55% vanish into thin air – a fall of 35% needs a rise of 54% to get back to the same price). That last profitable entry point was before the final parabolic rise in prices.
For bitcoin a similar scenario would imply that from an entry around $6000, price would need to reach $9000-$10000 before our exit would break us even – and this years rise in price feels like a parabolic move to me already!



Meb Faber analyses the use of a similar trend approach over the course of several historic bubbles in this paper.
In his discussion of the South Sea Bubble he finds a similar pattern (chart from Meb´s paper):

southseabuble

Because of the parabolic move in prices the trend exit would have given back 44% of paper profits from the high. In the chart from this example you can see that the entry point would have to be roughly after 2/3rd of the move at the very latest – just to break even.


We have to answer the question: how likely is it that bitcoin (after its current move of 600% this year) is still less than 2/3rd of the way to the top?


I don´t think, that that´s a worthwhile proposition – to make a profit prices would have to rise even higher before a major drawdown occurs.
When an asset is being hyped, the price has simply already been pushed up too high and probabilities are not in our favor.
Shorting the crash seems out of the question with such a volatile upwards move as we are witnessing – our downside would be unlimited and timing would need to be perfect.

 

I will just pass this one by until the odds improve and we see major real world implementation of blockchain technology – after a major drawdown in bitcoin price has happened and sentiment turns. Once we see the beginning of a new uptrend, that´s the time to consider investing.

 

As a final point, let´s view bitcoin in a portfolio context as that is really what matters most. Can bitcoin be a reliable portfolio diversifier like gold as it has an essentially similar store of value function?
Because the future of the underlying technology is potentially huge, but also very uncertain, bitcoin is more likely to behave like a technology stock, than a safe haven asset. It will probably fall into the same investor´s risk-on, risk-off behavior as volatile equities and become highly correlated to equities in a bear market. It can´t be relied on as a portfolio diversifier until the technology is more established.

 




2 Comments Add yours

  1. I think bitcoin and other digital currency would be our alternative “money” in the future. What I mean is in addition to credit cards, debit cards and cash, you could buy goods with bitcoin or other common digital currency. I understand bitcoin is probably still overpriced but in the long run bitcoin’s price would keep on increasing.

    Like

    1. david says:

      I agree, blockchain technology has the potential to hugely impact our lives, just as the internet. I´m just worried the path to higher prices is not likely to be in a straight line. And if bitcoin drops 50%-80% and than takes years to recover to new highs, I wouldn’t´t want to be part of that ride…

      Liked by 1 person

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s