Monday, November 27, 2017

Bitcoin, Blockchains, and Bubbles: Why We Might be Headed for a Crash.




Right now the US economy is doing pretty well. Unemployment is around 4%, and our economy has been growing at around 2% per year. These relatively good numbers are why Trump's approval ratings aren't even lower than they are. But the good times may not last much longer.

Predicting what the economy is going to do is notoriously difficult. But without getting too tricky, we can see that the US goes through some sort of economic crisis/recession thing every 10 years or so.

Here were the last six big ones:


  • 1960 - unemployment at 6.1%, 10 months of recession
  • 1973 - unemployment at 7.8%, 1+ year of recession
  • 1981 - unemployment at 10.8%, 1 year or recession
  • 1990 - unemployment at 7.8%, 8 months of recession
  • 2001 - unemployment at 6.3%, 8 months of recession
  • 2007 - unemployment at 10%, 1+ year of recession


Now it's 2017, about 10 years since the 2007 recession. So we should be at least a little concerned that another recession might be around the corner.

Another reason we should be worried is that the last two of these recessions coincided with the bursting of a “speculative asset bubble,” In the mid to late 1990s this was the dot com bubble, and in the mid to late 2000s it was the housing bubble. When these “bubbles” burst, it didn't just hurt people who bought tech stocks or mortgage bonds, it triggered a recession in the entire economy.

And we're in another one of these bubbles right now.

  

Asset Bubbles: What Goes Up Must Come Down


Speculative bubbles have been happening for centuries. Take the Dutch “tulip mania” in the 1630s. It started with a simple fad: fancy colored tulips became a hot status symbol, causing the price for them to rise. But then speculators started investing in tulips just so they could sell them for a profit when the price rose....which caused the price to rise even faster. It got to the point where the price for a single "Semper Augustus" tulip bulb was over 5,000 guilders. For comparison, a pretty nice  house in Amsterdam would only set you back 300 guilders.1

In 1637 everyone suddenly realized how insane this was, and the price collapsed. And anyone who had paid thousands of guilders for a tulip bulb was left holding...a tulip bulb.

These things happen all the time. In 1700s England there was the South Sea Bubble (in shares of the South Sea Company), and around the same time in France there was the “Mississippi Bubble” in shares of a French company that was looking for gold along the banks of the Mississippi river. And of course there was the US stock market bubble which burst in 1929, triggering the great depression.


"You might be in an asset bubble if...."


Since there have been so many speculative bubbles throughout history we've had lots of opportunities to catalog some of the obvious signs that can tell us when we’re in the middle of one. To help explain how these signs work, let's take a trip back to the late 1990s, at the peak of the dotcom bubble.

If you were around in the late 1990s you remember the hype about "dotcoms." The sock puppet mascot of "Pets.com" appeared on Good Morning America, and was interviewed by People. In 2000, during Super Bowl XXXIV we saw adds for over a dozen dot com start ups, including Autotrader.com, Computer.com, LastMinuteTravel.com, and Oxygen.com.

A few months later most of these companies went bankrupt, and the US economy was headed for a recession. But this shouldn't have been surprising.

If some asset - call it "X" - seems like the new hot investment, here are three things to watch out for:

Sign #1: You see absurd increases in the value of a company or product for NO GOOD REASON, just because it SOUNDS like the company or product might be related to X in some vague way.


For example, on November 25th, 1998 shares in the bookstore “Books-A-Million” were selling for $3 a piece. Then the company announced in a press release that it had redesigned its website. Note that Books-A-Million already had a website, they were just announcing that they had changed it slightly.

But tech obsessed traders just saw the word "website" and started buying like mad. Within a week the share price had jumped to $47, meaning that investors thought the company was worth more than fifteen times as much as it was before. Two weeks later, people realized how crazy this was and the price fell back to $10... still over twice as much as the company was worth before the press release. In 2000, after the dotcom bubble burst, the price fell right back to $3. 2

In 2015 the company was bought by a private investor for $3.25 per share.

Sign 2: Products and companies related to X rapidly become more complex and ridiculous, to the point where they don’t make ANY economic sense


During the 1990s bubble investors were willing to give millions to any company with ".com" in their name, no matter how dumb their business plan was.

Cyberrebate.com (founded in 1998) sold a variety of items at ridiculously inflated prices, but then offered customers a 100% rebate. So you might pay $300 for a printer that was worth only $60, but then you’d get a rebate for $300. How was a company like this supposed to make money? Well, the founders hoped that people would just forget to submit their rebates.

To make a long story short: they didn't. Cyberrebate.com filed for bankruptcy in 2001.

You also had Kozmo.com (Founded in 1998,  raised $240 million, went bankrupt in 2001), which delivered small items (magazines, coffee, DVDs, food) directly to your home for no delivery charge, and AllAdvantage.com (founded in 1999, raised $130 million, went bankrupt in 2000) which paid users to "surf the web" while viewing a banner ad.3

Sign 3: There is a dramatic increase in fraud and abuse related to X


At the height of a bubble people are so eager to throw money into anything related to the new hot thing that it's really easy to scam them.

In the 1990s there was Pixelon, which claimed to have developed high quality video-streaming technology (this was in the 1990s remember). The company’s founder “Michael Fenne” (alias David Kim Stanley) used $16 million of investor money on a launch party, featuring performances by KISS, Tony Bennett, and The Who. Six months later, Stanley was in jail for embezzlement, the technology was revealed to be bogus, and the company was bankrupt.

You may also have heard of the telecommunications company WorldCom, which engaged in a much bigger (although much less musical) fraud, overstating it's earnings by over $11 billion. But of course they didn't get caught until 2002, after the bubble had burst.




The Same Thing All Over Again


In the late 2000s all this happened again, only instead of dotcoms it was subprime mortgages. The details of mortgage backed securities and "synthetic CDOs" are insanely complicated (see sign #2 above), but all three of these signs were evident, and you can see them all in action by watching the excellent movie, "The Big Short," or - even better- reading the nonfiction book by Michael Lewis on which the movie is closely based.

During the housing bubble it was Dr. Michael Burray, the one-eyed, death-metal loving, t-shirt wearing, hedge fund manager/neurologist with Asperger's syndrome (played by Christian Bale in the movie), who first noticed these signs, and earned close to a billion dollars by betting against the housing market in 2005.

But you don't need to be a genius to notice a bubble. You just need to look around.

Are We in a Bubble Right Now?


Right now, the new hot thing in the US economy is called the blockchain.

The blockchain is a bit of technology that was originally developed for the digital currency bitcoin.

You've probably heard of bitcoin. It doesn't represent any tangible thing in the world -  it's just a bunch of ones and zeros. But some people think of it as money. You can use it to buy things from those people. But if someone doesn't think of it as money then you can't use to to buy stuff from them.

In other words, bitcoin is worth something if people think it's worth something, and it's worthless if people think it's worthless.

As crazy as it sounds this isn't that different from how normal money - like dollars and euros - work. We could spend a lot of time arguing about how different bitcoin is from normal money (it's a really interesting debate!) and if it should be worth anything at all. But for now let's just treat bitcoin like a tulip, house, or an internet company: a genuinely useful thing that just might be part of a speculative frenzy.

Back in March a single bitcoin was worth around $1,200. By November it was worth over $8,000

A price increase like that makes people say "wow, I've got to get in on that!" Then those people buy bitcoins, driving the price up further, which makes other people say, "wow, I've got to get in on that!" Then those people buy bitcoins, driving the price up further....

That's how it worked for tulips too.

But bitcoin's own price rise is just one part of a bigger mania related to the blockchain, which is the super-innovative technology that makes bitcoin actually work.

What is a blockchain?

A blockchain is a way to keep track of who owns a thing, and how much of that thing everyone owns. So if the thing is potatoes, the blockchain would keep track of how many potatoes I have, and how many you have, and if you give me one of your potatoes, then the blockchain knows that I know have one less potato and you have one more.

You could do this by just keeping a list, like in excel or something, but then someone has to be in charge of keeping the list and that means you have to trust that person not to just mess with the list to make it show that they have all the potatoes.

A blockchain is a way of keeping a list (really a "ledger") which no one is in charge of. So if you want to keep a list of something - like how much money each person has -  but don't trust any one person to be in chart of the list, then a blockchain can solve that problem.

How this works is pretty complicated, but here's a brief primer with more details:




There are now hundreds of other "cryptocurrencies" like bitcoin that use blockchain technology. Some of them like "Litcoin" and "Dash" really are (or want to be) forms of "digital money" like bitcoin. But the second most popular cryptocurrency - Ether -  is a "token" which is used to buy access to this...thing...called "Etherium" which is kind of like an app store for other blockchain related applications. The details are complicated.

So, is the blockchain a bubble, like dotcom companies in the 1990s? Let's check for our three signs...

Sign 1: You see absurd increases in the value of a company or product for no good reason, just because it SOUNDS like the company or product might be related to [the blockchain] in some vague way.


Here's an article with the title: "This Company Added the Word ‘Blockchain’ to Its Name and Saw Its Shares Surge 394%"

Here's an article about a different company, entitled: "A Biotech Company Changed Its Name to ‘Riot Blockchain’ and Its Stock Is Surging"

 We've also seen see a big spike in the price for domain names that are in some way related to blockchain technology.  You'd need a cool $10 million to buy "Etherium.com," or $2 million for "eth.com" but you could have bought "bitcoinwallet.com" for as little as $250,000.

Sign 2: Products and Companies related to [the blockchain] rapidly become more complex and ridiculous, to the point where they don’t make ANY economic sense

 

 Recently, people have started to use blockchain technology to do "Initial Coin offerings," or ICOs. An ICO is kind of like a cross between a initial stock offering and a kickstarter campaign....but with blockchain!

Let's say I want to start a company to sell, uh... synthetic rhino horn aphrodisiac  and I need some start up capital to get the business off the ground. I could take out a loan, or go to investors, or issue stock. Or I can sell blockchain-enabled "tokens" (or "coins") that users can exchange for synthetic rhino horn..if I ever end up selling any. Of course there's no guarantee that I'll actually start the business -much less that it will be successful - and there is nothing you can do to me if I decide to just take the money and run.

This may not sound that crazy, except that right now investors are shoveling huge amounts of money towards bizarre ICOs related to almost any concept imaginable.

Dentists?  You've got Dentacoin. Like bitcoin, but only for dentistry.

Cows?  There's "Cashcow," which aims to revolutionize Indonesian cattle financing.

The Wu-tang clan? There's Wu-Tang coin, which is not to be confused with the other Wu-Tang themed coin -  released by Ghostface Killah -  called "CREAM coin."

Harry Potter? Check out, MimbleWimble.


One of the hottest ICOs right now is Bancor, which is a "Decentralized Liquidity Network that allows you to hold any Ethereum token and convert it to any other token in the network, with no counter party, at an automatically calculated price, using a simple web wallet."

If I tried to explain what that means, we'd be here all day, but investors didn't care -  the Bancor ICO raised over $150 million in just three hours.

Sign 4: There is a dramatic increase in fraud and abuse related to [the Blockchain]


Cryptocurrencies need to exist online to work. Which means they can be hacked. And they are. Back in 2014 the most people used a site called "Mt Gox" to store their bitcoins, but then someone stole almost all of them - around 850,000 bitcoins - worth around $480 million at the time, and around $6 billion today. We still don't know who did it.

This sort of thing still happens all the time. Some scammers used a fake bitcoin wallet website to steal around  $30,000 in ether, $72,000 in litecoin, $107,000 in "bitcoin gold" and more than $3 million in bitcoin, and someone else stole $31 million worth of the cryptocurrency "tether" ...and all that was just this month. So far in 2017 thieves and scammers have stolen more than $200 million of ether, and in 2016 someone stole $65 million of ether in a single hack.

But why go to all the trouble of stealing cryptocurrency when you can just start your own and have people give you real money for it?

Some scammers, like those behind the Ponzi schemes "OneCoin" and "BitConnect" actually bothered to hide what they were doing.

But since we're in a bubble, hiding your intentions is optional. You can name your new cryptocurrency "Ponzicoin," explicitly tell everyone that it is a Ponzi scheme, and people will still send you over $7,000. Someone else raised over $40,000 for their "Useless Etherium token." As advertised, it does nothing.

Is it really a fraud if you tell people you are going to defraud them and they give you money anyways?


Bubbles Can Still Change the World (After They Pop)


Ok, so we're in a bubble. Despite all that, there are still good reason for thinking that the blockchain and bitcoin really could fundamentally change the whole world financial system.

But that's how it was in the 1990s too. The central thesis of the dotcom boom - that internet companies will end up dominating the US economy - was 100% correct. But it only happened after the bubble burst. Most of today's massively successful  "dotcom" companies - Facebook, Twitter, Google, Netflix -  didn't even exist during the mid 1990s.

Even if the blockchain ends up changing the world, Bitcoin, Etherium and Bancor might end up like America Online,  Netscape Communications and Lycos.

What about Amazon.com? Amazon was one of the earlier "dotcom" superstars, and look at it now!


Chart from the Motley Fool

But take a closer look at the rise and fall of Amazon stock right around 2000. When a bubble bursts even the good companies get crushed.  Between December 1999 and September 2001 Amazon's stock price fell from $106.69 to $5.96. If you had bought Amazon at the peak of the bubble, you would have had to wait close to ten years just to break even.

If bitcoin does succeed in transforming the world financial system, it will take decades. And before that happens, the current bubble will burst and bitcoin's price will tank.

So if you really believe in bitcoin, why not wait until this bubble pops and then invest?

When Will the Bubble Burst?


It's not hard to know that you are in a bubble. But predicting when the bubble will burst is almost impossible. The economist John Maynard Keynes had a saying:

"The market can stay irrational longer than you can stay solvent"

Even if we're pretty sure that the blockchain bubble is totally absurd, the market can sustain that absurdity for a surprisingly long time.  Michael Burray saw all the signs of the housing bubble in 2005, but the crash didn't happen until 2007. The signs of the dotcom bubble were obvious by 1995, but the market didn't crash until 2000. Because bubbles are driven by psychological biases rather than economic reality it's hard to predict how long they will last.

The blockchain bubble could all collapse in a heap tomorrow. Or it could continue on for years before collapsing. But every bubble collapses at some point. And when it does, you don't want to be the one holding the tulip bulb.



Notes:

1 Vogel (2010) p. 28

2 Lewis (2009) pp. 169-175

3 Lewis (2009) pp. 228-230


References

Lewis, Michael ( 2010). The Big Short. New York, NY, W.W. Norton and Co.

Lewis, Michael (2009). Panic: The Story of Modern Financial Insanity. New York, NY, W.W. Norton and Co.

Vogel, Harold, L (2010). Financial Market  Bubbles and Crashes.  new York, NY, Cambridge University Press.



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