Bitcoin Bull, 'It's A Bubble' (Pending:COIN-OLD-DEFUNCT-112452) (2024)

I am a Bitcoin bull, and you know this if you've read my previous pieces. Now I'm of the mind that we've entered bubble territory, but only just entered. When I wrote my pieces, back in the heady days of last month (!), Bitcoin was trading in high $3000s to low $4000s. Yesterday, it surpassed $7000 and today is even higher at $7200. The basic Wall Street gut reaction is that this state of affairs is outrageously unbelievable, while I think that this is merely getting ahead of things (and certainly not worse than Tesla).

The basic problem is a cognitive bias: our brains think linearly, and this phenomenon is not linear. The recent price increase has been accompanied with a massive upswing in average daily users. As a result, the Bitcoin network is nearly growing at a rate to support that price increase. Yet it is, admittedly, "jumping the gun" in anticipation.

To understand how this "jumping the gun" anticipation works out, we might want to look at the 2014 bubble. Now I'd like a larger data set, but Bitcoin hasn't been around for long, and previous Bitcoin bubbles make the 2014 bubble look tame. So to build in some margin of safety, I'll stick to an analysis of it alone. And to add a bit thicker margin, let's assume that things play out to half the "bubbliness" of 2014. If that's somewhat accurate, then we should be looking at $10,000 soon.

To set the stage, I'll start with the two news items that are increasing appetite for risk and show plainly why those news items cannot support the present price. This is the main reason why I think this is a bubble. I'll follow that analysis with a look at the 2014 bubble, which is what tempers my horror at the recent price action a bit. Finally, I'll close with some suggestions (if you're not it, wait for a 20%+ dip).

News Item One: CME Group's Futures

While LedgerX has already moved to trade derivatives on Bitcoin, doing about $1M in the first week, this week CME Group announced that it would also support derivatives trading. Since they are both established, and much larger than LedgerX, the announcement should be received well. But this news needs to be put into perspective, since it absolutely doesn't mean that institutional money will come pouring into Bitcoin in the next quarter.

The move is thought to be good news for three reasons.

• First, the SEC has denied attempts to form a Bitcoin ETF on the grounds that a futures market does not yet exist. With CME Group's derivatives market, the capital problem impeding Bitcoin ETFs would appear to be eliminated.
• Second, the existence of futures would allow traders and investors to hedge against Bitcoin's wild volatility, and that's been difficult to come by if you are a US investor who does not have access to the right Bitcoin exchanges.
• Third, the introduction of these sorts of products makes Bitcoin accessible to people who do not want to go through the ridiculous technological process of registering multiple wallets and exchanges simply to buy and sell Bitcoin. In short, it partially answers the user interface problem that all cryptocurrencies face.

I think these are all good points. But people are simply failing to understand the timeline of impact. It's helpful to recall that CME Group had already launched a price index back in November of, 2016, so this move isn't unexpected. Moreover, this slowness with registration (taking about a year to make an announcement for the next step) is typical of regulatory bodies. I'm not certain how long it will take for these futures to become widely available, but I'd be surprised if it happens within the next few months. As a result, all these wonderful effects simply won't materialize for a while. Conservatively I'd put the minimum time at 90 days, and in the Bitcoin world, that's an eternity.

Most importantly, there simply can't be mass adoption of Bitcoin right now, because the blockchain technology can't support larger volumes. The reason we've been having all these forks recently is because the technology cannot scale. At best, it presently does 3-4 transactions a second, which is lightyears away from Visa's 1500 transactions a second. In short, the investing infrastructure simply doesn't matter if "Big Money" can't buy enough Bitcoin. Until the scaling problem is fixed this news does not matter (and please read Vitalik Butterin's assessment of the problem even for Ethereum, which is much better off than Bitcoin is on this point).

News Item Two: The Next Fork

These points bring us to the next big fork for Bitcoin. Traders, and perhaps investors, were eager to buy Bitcoin before the last fork, because each fork gives current holders of a coin a new coin for free! It functions like receiving "dividends," and this is partly why cryptocurrencies can be considered assets.

Still, the coming fork is not like the last two. It is supposed to be the implementation of the second half of the New York Accord, which supported the development of the Segwit2x protocol. This protocol tackled the scaling problem in two parts:

• first, by segregating the witness of transactions (hence the SegWit part) off the main blockchain (see my detailed account here),
• and second, by increasing the size of blocks to 2MB (hence the 2x part) so that on chain volume could increase.

It was a compromise. Miners only make money through on chain transactions, but every developer knows that simply increasing block size will never come close to accommodating the volume from global demand.

Here is why this fork is different. SegWit can do all the scaling we need. Miners will just lose out on future profits, since those transactions won't be on the main chain. What is happening now is that the core development team has decided not to support the 2x block size increase (this is the NO2X movement), since it's unnecessary. Yet, by reneging on the New York Accord, it is unclear which coin will come out on top, and it also signals that blockchain agreements basically mean nothing. While the previous forks left a clear winner, so the smaller coin could serve as a "dividend," the worry now is that neither coin will emerge as victorious. As a result, holders of Bitcoin could end up with two coins at half value, neither of which has a clear future.

This fork, then, could sunder Bitcoin, rather than simply dole out "free money."

The Previous Bubble

What the above suggests is that Bitcoin's price increase is "jumping the gun," and that we're likely entering a bubble. So what can we expect?

I continue to insist that Metcalfe's Law has done a pretty good job of identifying Bitcoin's value, since it is both consistent with much of its actual value, and has accurately identified bubbles in the past. Also it has peer-reviewed support explaining other networks (including Facebook and Tencent), as well as Bitcoin in particular, see Ken Alabi's article. To identify bubbles, I simply assess the price of Bitcoin relative to its Metcalfe value, which produces a P/MV ratio. You can think of that as a little bit like price to book for a firm.

Let's look at the following chart, which shows the relation of Bitcoin's price to the value of the network using Metcalfe's law (green is for dollars and orange is for Metcalfe value).

Viewed this way, it clearly looks like a bubble. In 2014 when the price of Bitcoin exceeded the Metcalfe value by too much, it crashed back down. Today the price of Bitcoin looks to be doing the same thing.

Yet this is a linear chart, and so it scales things according to our brain's cognitive biases. Networks tend to gain value non-linearly, so we need to fix the chart to avoid that bias. What happens if we look at the data when scaled logarithmically (with green for USD and orange for Metcalfe value)?

Now we see that our current "bubble" is just beginning and could have quite a bit of room to run. Could it crash down from here? Sure. But most Bitcoin bubbles appear to last at least a year, and have much more precipitous climes.

If we look at the 2014 bubble, we find that it's average P/MV was above 5 for the whole period (including much of the decline), and that it topped out above 27 (though its 20-day average was actually closer to 16x). If we use those numbers to assess what is presently happening with Bitcoin, we see that even this recent price increase is not too worrying.

These projections are modest. They assume that there will not be much growth in the actual Bitcoin network, since scaling will not be possible until the Lightning Network is functional. That will only happen after the present fork (SegWit without 2x), and likely another 12 months after that. What they do assume is that there will be an expansion in the P/MV value. If that expansion hits what has been typical (the average, including the crash) since 2014, it should move to 3.8. If it rises into a bit more "bubbliness," then a multiple of 5.5 is likely. That sort of expansion already puts Bitcoin over the $10,000 mark. If the bubble expands to hit half of the 20-day moving average during the 2014 bubble, Bitcoin will go over $18,000.

Concluding Thoughts

Given the above, what are we to think about the present price increases? I think it's a beginning bubble.

The recent price increase to $7,200, however, does not change the story that's been developing since this summer: we are seeing a return to an expanding set of expectations relative to the network size (the number of people using Bitcoin). The recent news stories add to these expectations, and I think people buying now are overly optimistic. However, there is still a case to be made that even buying in now, one is likely to make money assuming a return to the average P/MV since 2014.

One might (again) object that this timeline is too short. I'm sympathetic to that concern. My reply is to point out that this timeline is the most pessimistic I could find. If one uses the full range of historical data, then the average P/MV turns out to be closer to 6, rather than 3.8. Previous bubbles, moreover, had even more precipitous increases, with even higher P/MV multiples. On an historical basis, this is the most conservative I could make these numbers, and then I even halved those values to add a further margin of safety.

A final objection might be that the analysis is incomplete without a look at the risks. I agree. The downside risk, to my mind, is that Bitcoin would return to Metcalfe value (this is what it has done in previous crashes). Presently, that would put its price at $2,200, which is quite a decline from the present case. Still, we would need to have reasons for that sort of crash, and I've been unable to find many. Mostly, I think, we'll run into delays (as has been the case with Tesla's over-promising lately). If that's right, then you should probably wait to buy in until we hit one of those delays, which will cause a temporary fall in price (at least 20%), to buy in if you are inclined towards Bitcoin at all.

That's it! Let me know your thoughts in the comments!

Lynn Sebastian Purcell