Bitcoin (COIN) (GBTC) is presenting a great story right now as it has all the important ingredients to create noteworthy headlines. In only 30 trading days, Bitcoin (compared to the USD) has lost nearly 50% of its value and such a steep decline is justifying to use phrases like "crash" or "meltdown" - words that create attention. If it was the US stock market that lost 50% of its value within only 30 trading days, I am sure I would read articles about the world ending. But under the conditions of a bubble, such a steep decline can be rephrased and is only a temporary setback and a one-in-a-million buying opportunity. And there we have another buzzword that is used way too often: bubble. All these words like bubble, rally or crash are widely used by authors who write about the stock market because they create attention (I am hardly an exception). We are all using these words way too thoughtless, but with Bitcoin (and other cryptocurrencies), all these words are justified and in no way an exaggeration. Bitcoin is a textbook example of a bubble and an excellent chance to study how such bubbles are created. According to Gartner, it takes three steps in the hype cycle until the peak of inflated expectations is reached and the bubble will pop. The following article is structured in three sections following the three steps described by Gartner.
Part I: Innovation trigger and premises
Not every new technology is creating a massive hype and not every tradeable asset is creating a bubble. In the first stage, only a few selected people know about the new invention or the new technology. These guys are usually experts in a field and probably work in the research and development department or are scientists. Additionally, we have a few other people that are interested in the new technology. At that point, an overwhelming majority of the world population has never heard about the new invention and if someone would tell them, they would find it extremely boring, they wouldn't care and probably understand nothing about the technology. But already at that early stage, the asset has a few characteristics that seem to be necessary to create a bubble as not every asset class seems suitable for inflated expectations at any time.
Something new, something exciting
Humans are usually attracted by new objects, new locations, new places - it is not the known and familiar that is fascinating for us, but the unknown and new. We are drawn towards new innovations and technologies because they are fascinating for us. Technologies that have been around for decades can hardly get people as excited as the new inventions. Nevertheless, it may take some time before a new technology might create a hype: the internet existed already a few years before the dotcom bubble occurred, and Bitcoin also existed since 2009 and the price has already seen a few "small bubbles", but it took until 2017 to enter full madness.
Compelling story
For the new technology to provide a compelling story, some criteria have to be met. An asset bubble can only occur when expectations about the value of an asset can reach astronomical levels as the price of an asset (whether it is gold, stocks or currencies) always reflects these future expectations. The technology, therefore, should have the potential to alter people's lives sustainable - at least in people's imagination - because this is the basis for inflated expectations. The technology should have the potential to get people excited and tickle everybody's fancy about changing the world. Although nobody is writing about the new technology or asset yet, it has to be exciting and newsworthy and providing the opportunity for great stories that can be picked up by the mass media.
On the one hand, the technology should be complex and rather difficult to understand. This provides the perfect soil for crazy fantasies. If one can't see clearly what a new technology can accomplish and what not, it provides the possibility to fantasize in crazy ways about. On the other hand, especially today with Twitter (TWTR) and similar social media platforms which don't really support long and complicated articles, it should have the potential to be described in just a few words (even if this means a drastic reduction in complexity that doesn't meet the standards of describing the technology at all).
Part II: Building the bubble
We have to understand that the people interested in the technology in the first place are seldom the people interested while the technology goes through its hype and the underlying asset is creating a bubble. Those interested in the technology at the beginning are the ones understanding the technology and trying to develop and making it better and they are seldom interested in making a fortune. But then we can witness a shift from those people that are truly interested in the technology and understand it towards those people that are solely interested in getting rich and see the underlying asset just as a way to do it but don't care about the technology at all.
(Source: https://trends.google.de/trends/)
I think the search volume for Bitcoin and Blockchain compared is showing how those who were interested in the technology (Blockchain) are replaced by the gamblers and speculators that are just interested in the asset (Bitcoin). But for that shift, a few steps have to be taken.
Spread of ideas by mass media
A bubble requires market participants buying a certain asset and pushing the prices higher and higher. In a first step, people have to be aware of a certain asset, and therefore, we need constant reports about the asset to get many people's attention. I assume that many people outside the financial market didn't hear about Bitcoin or cryptocurrencies until a few months ago. "Significant market events generally occur only if there is similar thinking among large groups of people, and the news media are essential vehicles for the spread of ideas." (Shiller, p. 71). The history of bubbles begins roughly around the 1630s with the Dutch tulip mania and it is no coincidence that the advent of newspapers falls in the same time (see Shiller, p. 71). A bubble, however, doesn't require newspapers in particular - radio, television or Twitter and Facebook (FB) work just as well. It is irrelevant how the information is distributed - it is only important that the information reaches a very large crowd. Google is of course just one way to search for information, but it shows very impressively how interest in "Bitcoin" has exploded in the second half of 2017 - exceeding other investment topics like gold, USD or the stock market in general.
(Source: https://trends.google.de/trends/)
However, it is not just the Google search volume for Bitcoin that increased extremely - the number of tweets also increased from about 20,000 in the end of 2016 to about 150,000 in December 2017.
Forming similar opinions
But it is not enough if a lot of people are searching for a certain topic and if that topic is suddenly popular due to massive media coverage. People not only have to be aware of an asset but also form a similar (bullish) opinion about the asset - otherwise, a bubble is not possible. If a few people assume that the asset should be worth much more and some others have the opinion it should be worth less, there won't be a bubble. Usually, people can have many different opinions about a certain topic, but for financial assets, it is very easy to categorize in only three groups - those that are indifferent, the bulls expecting higher prices, and the bears expecting lower prices. I am aware that this categorization is an over-simplification of facts, but compared to other topics, it is quite easy to categorize opinions about financial assets and this is supporting the existence of strong sentiments that many people fall for without calling the bullish (or bearish) opinion into question.
Shifting in allegedly safe investments
A third and final aspect that is not really a condition for a hype but can often be witnessed when bubbles occur is the piling into new investments after the investment in another asset has gone dramatically wrong. In many cases, there has been a bubble before and after that bubble busted investors fled in "safer" investments creating another bubble. After the dotcom bubble burst, investors shifted to the housing market as stocks were considered as too risky and created the housing bubble, that lead in consequence to the financial crisis. After the financial crisis with all its horrible consequences of quantitative easing and the dwindling trust in the monetary system, investors now seem to be eager to move away from established currencies to "safer" cryptocurrencies that can't be deflated and will allegedly solve many problems.
Part III: Crazy time
With media constantly reporting about the new technology plus many people forming a similar opinion about the asset, we enter the final stage of the bubble and build up towards the peak of inflated expectations. It is not really clear how long this phase can last - maybe a few months or several years. One would have to assume that this final stage will be over after a few months, and the hype will soften again. However, we are dealing with a vicious cycle and events reinforce themselves. Financial markets are an extremely complex system, and therefore, we experience feedback loops and characteristics of self-fulfilling prophecies. Some of the events and characteristics that reinforce themselves are people challenging valuations, the fear of missing out, new era thinking, and confirmation bias.
Confirmation bias
Above we already learned that the media is creating attention and is responsible for different people having a very similar opinion about an asset. When we are already in the bubble phase, it is hard to discuss about the asset in a constructive manner.
"As you start to consider some innovation, you start to collect evidence for and against it. Or do you? Unfortunately, people tend not to look equally at both sides of a question. We all have a strong bias toward seeking out and collecting evidence that confirms our existing or preferred view." (Fenn/Raskino, p. 34).
Critical voices are usually shut out as they just don't get it and seem too stupid to understand the revolution that is going on. This phenomenon is called confirmation bias and was described already in 1960 by P.C. Wason. Studies have shown that confirmation bias is bringing people not just to search one-sided for information that confirms their opinion, but they will also interpret information in a way to support their pre-existing opinion. From confirmation bias, it is just a small step to delusion.
"Delusions are best understood not as deficiencies in logic, but rather as explanations that have been logically reached on the basis of distorted inputs. […] The reason that delusions are so hard to fight with logic is that delusions themselves are established through the exercise of logic. Responsibility for delusions is more likely to be found in distorted perception or inadequate information." (Hussmann, John P.)
Valuation metrics are challenged
Another characteristic of bubbles are the extreme valuations because otherwise, it couldn't be a bubble. However, it is not just the extremely high valuation itself as assets can be overvalued without being in a bubble (the US stock market, for example, is extremely overvalued in my opinion, but not in a bubble). Important for a bubble is that people are denying that valuations are much too high and being not capable to recognize that valuations are important. The denying of high valuations is going hand in hand with different sorts of justifications why the extreme valuations are not really extreme and in such crazy times, valuation metrics are often defined new.
"Faced with extreme valuations, the first impulse of investors should not be to try to justify those valuation extremes, but to recognize the impact of their own speculative behavior in producing and sustaining those extremes. It then becomes essential to monitor market conditions for the hostile combination of extreme valuations and deteriorating market internals." (Hussmann, John P.)
In the case of Bitcoin, we have to add that there seems to be hardly a reasonable way to determine an intrinsic value. During the Dotcom bubble, different ways to evaluate a stock that has been proven right for decades were suddenly challenged, and P/E ratio of 100, 200 or 300 were suddenly justified. The simple argument was based on the internet changing everything and old valuation methods were not applicable anymore. However, there were at least ways to calculate an intrinsic value. For Bitcoin, on the other hand, all numbers what it should be worth (I have read estimates as high as $1,000,000) seem to be made up.
Fear of missing out
Although people seem not really know what Bitcoin is and have absolutely no idea what the asset should be worth, they are caught by FOMO. The acronym stands for "Fear of missing out" and is describing a common state of mind during bubbles. "The stories in the press capture the excitement around the innovation and reinforce the need to become a part of it or be left behind." (Hype Cycle, p. 8). If you miss the chance to invest now, you will never find an opportunity to invest again and you will miss out on the chance of your life and regret it forever.
The risk of getting caught up in FOMO is quite high. And that particular fear gets greater and greater if an asset is doubling, tripling, quadrupling within a very short timeframe as it only takes a few days or weeks and you can already regret missing out on 100% or 200% gains. Additionally, if you have to read about success stories of people getting rich thanks to cryptocurrencies and some guys you have never heard of before are among the richest people in the world thanks to cryptocurrencies, you might feel like the biggest idiot walking the earth as everybody around you seems to get rich except yourself. And although you don't understand what bitcoin is, you will invest.
New era economic thinking
When bubbles occur, aside from the fear of missing out and challenged valuation metrics, we almost always find some variation of the so called "new era economic thinking" - a time that has "often been associated with popular perceptions that the future is brighter or less uncertain than it was in the past" (Shiller, p. 96). Thanks to some new technology, many different people are expecting a big dramatic shift in the near future that will break with many rules we know and also will make current valuation metrics useless (see chapter on valuation). The dotcom bubble is once again a good example.
"It was the 'new economy' and it had 'new rules'. Conventional business wisdom no longer applied. Anyone who didn't share the enthusiasm clearly didn't get it, to use the popular put-down of the era. The financial press, business journals, business thinkers, stock market analysts, venture capitalists, even the annual reports of blue chip companies, all caught the Internet bug." (Fenn/Raskino, p. 15f.)
A lot of people need to believe that they are not just witnessing some new innovation or a small alteration, but rather a dramatic shift that will change the world as we know it. The dramatic shift has to affect different systems and a change will not just happen in the financial system but also in the political system and academia and it will also have an impact on the legal system and educational system. We are talking about changes that challenge the foundations of our society.
"A more subtle, but equally contagious influence is the impact of the zeitgeist, or the "spirit of the time". A common social framework of attitudes, outlook, values and expectations works its effect subtly in ways that cut deeper than short-term fashion shifts." (Fenn/Raskino, p. 33)
In many cases, the new area economic thinking was not total rubbish. Sometimes there was indeed a new technology or something innovative that had a big influence on society - the blockchain technology can have a big impact just as the internet did have indeed a big influence. But expectations are so extremely exaggerated that they don't reflect the real valuation of the new technology anymore - creating the bubble and the hype.
Feedback loops
We already mentioned the feedback loop as reason for long-lasting hypes. Financial markets are by nature very complex systems and a fertile soil for various feedback loops. People hear success stories of others and assume they can become similarly rich when they invest which is driving the price up and confirmation for everybody else that Bitcoin will continue to rise. Increasing prices are increasing the fear of missing out, people crack and invest themselves driving up the price again, creating success stories and increasing FOMO for everybody else.
But complex systems are not only fertile soil for feedback loops but they are also extremely fragile and constantly have to process different irritations and provocations in order to keep the complex system stable. Every new piece of information has to be processed according to the "code" of the system, and at some point in time, there is that one piece of information that can't be included anymore and the whole story of valuations being irrelevant and new era economic thinking collapses. And the term information has to be understood in a broader (sociological) sense - a piece of information can be a story on the news, the opinion of some hedge fund manager, but it can also be such a powerful disturbance like big investors start selling and margin calls occurring as the asset price drops.
Conclusion
My advice is the same as it would have been a few months or one or two years ago: Stay away from Bitcoin and any other cryptocurrencies. Stay on the sidelines, watch and learn how bubbles are created and how bubbles burst. Blockchain may be what the internet was in the dotcom bubble - the underlying technological revolution that will survive and alter our lives and maybe some of the cryptocurrencies may survive as well. But you can be sure, that more than 99% of existing cryptocurrencies will be worth nothing - and the chances of Bitcoin, Ripple, Ethereum or Litecoin being among them are pretty high. Has the Bitcoin bubble already reached its peak of inflated expectations? The 50% decline in value and the sharp decline in Google search volume might suggest we already reached the peak, but I don't know. Just watch and learn - it doesn't cost anything but will provide a lot of knowledge. And the story has not to be over yet as Amara's law suggests we might be just at the beginning of a new technology:
"We tend to overestimate the effect of a technology in the short run and underestimate the effect in the long run." (Roy Amara)
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Literature:
Jackie Fenn & Mark Raskino (2008). Mastering the Hype Cycle: How to Choose the Right Innovation at the Right Time. Harvard Business Press.
Shiller, Robert J. (2000): Irrational Exuberance. Princeton University Press
Daniel Schönberger
My analysis is focused on high-quality companies, that can outperform the market over the long-run due to a competitive advantage (economic moat) and high levels of defensibility. Focused on European and North American companies, but without constraints regarding market capitalization (from large cap to small cap companies).My academic background is in sociology and I hold a Master’s Degree in Sociology (with main emphasis on organizational and economic sociology) and a Bachelor’s Degree in Sociology and History.I also write about wide economic moats in my Substack:https://stockmarket101.substack.comI also write about investing, economy and similar topics on Medium: https://medium.com/@danielschonberger
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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