Is Bitcoin A Bubble?

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"Is it a bubble?"

This is an essential question that investors in any fast-rising market or sharply rallying asset should ask themselves. Unfortunately, it's much easier to answer this question in retrospect; one could argue that, if a bubble were visible from up close, it would lose its appeal to investors -- and burst as a result.

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Regardless of whether warning signs are visible, an unraveling bubble is a difficult pill to swallow. So, if asking the right questions can help prevent a bubble from getting bigger, we should keep doing so. And if it's not a bubble, even better; besides a missed opportunity, not much will be lost.

Anyone who ever questioned a bubble and got out before it popped -- whether it was tulip fever in 17th-century Europe, a rally in the Japanese markets of the late 1980s, or the internet mania of 1999 -- would have ended up in better shape than those who didn't.

The same "bubble" question is being asked about bitcoin today. After doubling and redoubling and then doubling again a few times more this year (the price of the cybercurrency was up nearly 80% in the first two weeks of December alone), this relatively new asset is clearly exhibiting the signs of rabid speculation.

Pundits, investors and authority figures are all lining up on both sides of the argument.

The most prominent warning calling for investors to be cautious came just after the U.S. Federal Reserve announced an interest rate hike earlier this month. Janet Yellen, the current Fed chair, called it a "highly speculative asset" based on the conventional wisdom of traditional finance. (She also pointed out that it's not a widely accepted currency.)

On the other side, institutions and traders are positioning themselves to benefit from the growing public interest. Traders couldn't wait to jump on the bandwagon, too... Not just one, but two major exchanges officially launched bitcoin futures this month. First was the CBOE, which started listing bitcoin futures on Dec. 10; that was quickly followed by the competing derivatives exchange CME, which started listing bitcoin futures one week later. The futures markets let participants bet on the future direction of the cryptocurrency by providing the means to lock in a selling price for it as of a future date.

But let's get back to financial theory. One sign of a bubble is the absence of rational reasoning motivating buyers; they buy because the asset is going up. On the other hand, that line of reasoning may be hard to apply to a brand-new asset.

But investors still need a rational answer, if for no other reason than to protect themselves from getting hurt if it is a bubble.

Just ask anyone who bought into Japan's Nikkei 30 years ago. As of mid-December, most of them have still not broken even. Of course, many investors hate missing new opportunities... especially ones where you have the potential to get rich practically overnight.

Source: Bloomberg

Finding Answers In The Past
Let's think rationally about the "whys" and the "hows" of this new asset. This should help get us closer to finding an answer to the "bubble" question. Because none of us can predict the future, logic is the best tool available.

Gold is the closest asset to bitcoin that comes to mind; I think its history and its price dynamic can help us evaluate today's price action of bitcoin.

Indeed, gold and bitcoin have much in common. Both are currency-like assets. The total amount in existence for each of these two assets is limited. For all intents and purposes, all the gold ever mined still exists today; a similar quality applies to bitcoin, too. And just like how it becomes more and more expensive to extract additional quantities of gold as supply diminishes, it also becomes more expensive to mine bitcoin; because of the math behind its main equation, every new batch of bitcoin is more expensive than the earlier ones.

And so, despite the obvious differences between gold and bitcoin -- e.g., gold has applications beyond its monetary uses, such as jewelry and electronics -- gold and its price history could guide us as we address this question.

Over the past 50 years, the price of gold has been in an uptrend. But over this period, even this millennia-old asset has seen a couple of bubble-like price peaks. It took 25 years to recover the price level beyond the first peak of 1980, and we are still about 35% below gold's 2011 levels. There is value in gold, but it changes over time.

Because bitcoin aspires to become legal currency, its value should be more or less stable. Nobody uses money when it's of an undetermined value, especially when they have a choice; the purpose of any currency is to measure value and to serve as the means of payment. So, until bitcoin prices settle at some level, its main use as money is impossible.

Considering bitcoin solely as an investment, its value cannot rise indefinitely, either -- at some point, some investors will start selling and bitcoin's price will fall. As with any investment, good ol' fashioned supply and demand will become the main determination of its market value.

The problem is that nobody is sure whether bitcoin is money... or an investment. This goes hand in hand with bitcoin's status as a brand-new entity.

So here's my answer: Bitcoin is an asset class in search of an equilibrium price. This price discovery process is unlikely to proceed without the market price getting excessive. It's also quite possible that the "real" price of bitcoin is higher than what it trades for today. But using history as our guide, it's more likely that this process of price discovery will be volatile, and that the current price will deflate before a true pricing mechanism is established.

Of course, this time could well be different. But history does tell us that it's dangerous not to take the past into account. Let's remain vigilant and understand the risks, especially when it comes to an asset that jumped more than a thousand percent over the course of a single year.

Even Better Than Bitcoin
Why deal with bitcoin's volatility when you can get huge returns from traditional stocks?

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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