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August 21, 2017

The New Bitcoin and Cryptocurrency Bubble

By Charles Rotblut, CFA, AAII

Bitcoin rose above the $4,000 price mark, adding to this year’s surge in value. The New York Times attributes the most recent upward spike to an agreement among key backers to settle “a long-disputed update to the network’s software and rules.” Regardless of the reason given, the price action exemplifies unfettered speculation.

To be fair, there are those who view bitcoin and other cryptocurrencies as alternative means of storing wealth. Cryptocurrencies are not issued by central governments nor controlled by central banks. They are tradeable globally as long as someone has an internet connection. In the case of bitcoin at least, there is a limit to how many can be ever created.

Still, the introduction of “ICO” (initial coin offering) to Wall Street’s lexicon smells of tulips, Dutch tulips to be specific. Ethereum, a competitor to bitcoin, raised more than $150 million. Tezos, another blockchain provider, raised $232 million last month. (In simplistic terms, a blockchain is an online ledger of transactions. Ethereum and Tezos have their own cryptocurrencies.) Business Insider tabulates that more than $1 billion has been raised through ICOs so far this year. The digital coin offerings have even sparked the Securities and Exchange Commission to issue an Investor Bulletin about them.

Backers and speculators are gambling that one or more of these alternative currency platforms will achieve a lasting and sizeable scale. They face many hurdles, however. While many people may have heard of bitcoin, most probably have no idea how to get it or what to do with it. Far fewer have any idea what an ether or a tez is. The number of people who are willing to transact in any of them is even smaller—much, much smaller. Go to your supermarket chain, your car repair shop or your plumber and ask them if you can pay with bitcoin. The answers will be no, no and no. Even e-commerce giant Amazon does not accept bitcoin.

For a currency to have any value, people have to be willing to transact in it and agree on a certain value for it. The dollar, the loonie, the pound, the euro, the Swiss franc, the yen and the renminbi are all widely used and accepted. While critics like to toss around the term “fiat currency,” mainstream currencies are backed by national governments and are globally accepted. There is never a problem transacting with dollars at a gas station in the U.S., in loonies at a grocery store in Canada, in yen at a restaurant in Japan, in euros at a bakery in France, in pounds at a pub in England or in renminbi with a manufacturer in China. No matter how much hype cryptocurrency backers like to spread, the use of bitcoin and competitive cryptocurrencies remains limited to the fringes of the global economy.

So why is bitcoin now worth more than $4,000 and why are ICOs attracting large sums of money? Unfettered speculation is a reflection of a lack of historical knowledge. In “Memoirs of Extraordinary Popular Delusions and the Madness of Crowds” (originally published in 1841), Charles Mackay wrote the following about the 17th century Dutch tulip bubble: “Everyone imagined that the passion for tulips would last forever, and that the wealthy from every part of the world would send to Holland, and pay whatever prices were asked for them.” Charles Kindleberger, in “Manias, Panics and Crashes” (John Wiley & Sons, 2000), lists metallic coins, sugar, coffee, foreign bonds, agricultural land, copper and gold as having been “objects of speculation” in the past, just as tulips were. None of these bubbles ended well—a lesson that should be heeded by those who are currently investing in or trading cryptocurrencies and related blockchains.

The Week Ahead 

Just 17 members of the S&P 500 are scheduled to report as second-quarter earnings season starts to wind down. Among the large-cap companies on the calendar are Medtronic PLC (MDT) and Salesforce.com Inc. (CRM) on Tuesday; Lowe’s Companies Inc. (LOW) and HP Inc. (HPQ) on Wednesday; and Broadcom Ltd. (AVGO) on Thursday.

The week’s first economic report will be July new home sales, which will be released on Wednesday. Thursday will feature the August Purchasing Managers’ Index (PMI) and July existing home sales. Ending the week, July durable goods orders will be released on Friday.

The Jackson Hole Economic Policy Symposium will begin in Jackson Hole, Wyoming, on Thursday and continue through Saturday. The annual meeting will include speeches by Federal Reserve chair Janet Yellen and European Central Bank president Mario Draghi.

Only one Federal Reserve official will speak this week at an event other than the Jackson Hole Economic Policy Symposium. Dallas president Robert Kaplan will speak on Wednesday.

The Treasury Department will auction $13 billion of two-year floating rate notes on Wednesday and $14 billion of five-year inflation-indexed securities (TIPS) on Thursday.

About The Author - Charles Rotblut, CFA is the VP and Editor for American Association of Individual Investors (AAII). Charles is also the author of Better Good than Lucky. (EconMatters author archive here

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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