Is Bitcoin In Bubble Trouble?

It doesn’t give me any pleasure to say this, and I hope that I am wrong, but bitcoin is showing every sign of being in a bubble. Some have been saying that for a while, and I addressed those claims in an article in May when the price was approaching $3,000, concluding that we were at that time nowhere near the top. Now, however, things have changed. There are a few sound, fundamental reasons why the virtual currency has risen sharply this year, but there are now just as many reasons, both technical and fundamental, to believe that the move has gone past its logical endpoint. That doesn’t mean that it is necessarily about to collapse, but it does mean that those holding the virtual currency should exercise some caution.

Long-time readers of Market Musings will be aware that I have written extensively on Bitcoin and other cryptocurrencies, and I repeatedly reiterated that the currency’s underlying protocol and its disinflationary model made price rises almost inevitable. That protocol allows for a maximum of around 21 million bitcoins to be discovered, or “mined”, with the rate of supply decreasing over time. The most basic economics of supply and demand dictate that with that limited and decreasing supply, price will rise if demand merely remains level. What we have seen this year, however, is an explosion in demand that has led to a 1-year chart that looks like this.

From a technical perspective, what's worrisome is the recent volatility, and by that, I mean rapid, illiquid moves in both directions, not just a downward correction. Once the $10,000 level was breached this week, $11,000 came immediately behind it, then the price immediately lost over twenty percent in one day. That is pretty drastic, even for the typically volatile BTC/USD market, and the top of any overdone move is typically marked by a period of excessive volatility. That was the case with stocks in 1929, 2000 and 2007 among others, and it was the case with oil at the top and bottom in 2008 and again at the bottom in January of this year.

That is a slight cause for concern, but there are other things that are troubling, particularly to those who believe in, rather than simply trade bitcoin. The volatility possibly indicates the top of the move up, but it definitely indicates a shift to more speculative investment. What is driving gains at this point is fast money that will exit as quickly as it entered on downward momentum, which raises the specter of a rush to exit a crowded trade.

Moves to mitigate that to some extent and provide more liquidity in the market are out there, but they create their own problems. There are an increasing number of derivatives available based on bitcoin, and a futures market is imminent. The main problem is that, by definition, these derivatives involve trading with leverage and make it easier to create a short position, while making long positions more vulnerable to margin calls should a correction come. If the market is overextended those two things combined could easily turn what should have been a normal, healthy correction into a rout.

Bitcoin believers, while obviously pleased to see prices up here and by the ever-increasing number of mainstream converts, are particularly worried and upset by the increased leverage in the market. Bitcoin’s early popularity was in part a result of it being an antidote to the excessive leverage that led to the crash of 2008, and its role as an alternative currency was a direct challenge to the power of the big banks and even central banks. Now it is those same banks that are offering and encouraging leverage on bitcoin, and even the Fed is considering launching its own digital currency.

Back in January of 2015, I wrote, in this article, in which I said that the financial establishment typically goes through three stages of reaction when challenged. First it ignores the problem, then argues vehemently against it and tries to get it regulated away, then, when all else fails, they buy it. I wrote back then that the Wall Street backing given to Coinbase was a sign that that third stage was beginning, and the derivatives being created by Wall Street and the interest from the Fed suggest that it is now fully in operation.

Bitcoin has another problem right now as well…it is way too popular. There is an oft-repeated story about Joe Kennedy, who decided to sell his stocks in 1929, just before the crash, when his shoe-shine boy started giving him stock tips. The fact that my inbox is now flooded with e-mails from “experts”, most of whom had probably not even heard of bitcoin a few years ago, or if they had, were among those saying, “It isn’t real, so can’t be trusted…” is an indication that bitcoin is at its own shoe-shine boy moment.

The level of hype that we are now seeing, when combined with increased use of leverage is a recipe for disaster, but, as I have frequently said in other contexts, market moves can continue way beyond their logical end. I still believe in the fundamental utility of bitcoin, but at these levels, as I said earlier, caution is advised.

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

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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