Increasingly, there are articles all over the news about how the next bubble is near. I have been investing and reading financial news for almost ten years now and I promise you it has always been this way. And you know what? Not a single person was writing about COVID 19 before March.
That’s how actual economic shocks work, they come from things that no one is betting against or talking about. Here’s some excerpts from a Motley Fool article circa January 2020 which show why these predictions are mostly noise.
Alright Not a Bad Start
2020 Was a Hell of A Year
Netflix is up around 50% over the last year
Bitcoin is up 400% over the last year
I don’t plan on calling the next market bubble and I love the Motley Fool so this is not a jab at them. What I am beginning to question is how mainstream Bitcoin is becoming. I have recently been reading a lot about the Great Recession as well. To me, it seems there are some eerie parallels between the growing pervasiveness of Bitcoin and the wide spread presence of mortgage backed securities in the early 2000’s. Both of these were difficult to value and ended up being falsely perceived as safe. Without making a prediction, let’s ask the important question for where we’re at right now.
Before we get to that let’s look at what Bitcoin actually is.
What is a Bitcoin?
- Bitcoin is a digital currency that utilizes blockchain technology.
- There are currently 17 million in circulation and 21 million is the ultimate cap on how many there can be.
- There are algorithms that computers run to mine Bitcoin. The algorithm requires more computing power for every bitcoin mined. At this rate it will take 122 years for the remaining 4 million to be mined.
Unique Factors of Bitcoin
- There is no central controlling authority because block chain technology is decentralized. If you lose your password to your coin bank there is no help line or anyone you can call. Just ask these guys.
- There’s not actually bitcoin. Like bitcoin are not digital certificates or something tangible. As Bitcoin is traded, multiple computer servers record the transactions. Your “Bitcoin” are simply part of this tally of who has what.
- We don’t have a system for valuing Bitcoin. How do you value a tally of things that don’t actually exist? It’s much more difficult than the stock of a company that makes money selling actual tangible goods or a metal such as gold which has intrinsic value.
It’s a pretty insane concept so here’s a quick video to help.
Bitcoin has absolutely crushed the stock market as an investment. Because of its scarcity, decentralization and success it has gone from fringe investment to mainstream. Companies and large firms are increasingly viewing it as a store of wealth similar to gold. It’s tempting to draw that parallel but remember gold is actually a physical object that you lay claim to when you purchase. Bitcoin is a transaction ledger of things that don’t actually exist. That’s a little different.
Bitcoins success is actually where the risk lies. I don’t think it’s bullish run is over at all, which will continue to suck more people in. Now that mainstream companies like Tesla and Square have purchased bitcoin, executives at almost all companies are at least thinking about whether they should buy it to add to their balance sheets. If Bitcoin’s run continues then it’s likely more companies will give in to this temptation to capture some upside. Furthermore, Bitcoin ETF’s are being bought hand over fist by retail and professional investors alike.
Therein Lies The Risk
The more successful Bitcoin is the more it will continue to permeate throughout our financial world. This is an asset that no one understands how to value and that there is no central figure to provide regulation or assist when it crashes. Bitcoin has shown that it can halve in value in just a few days yet more companies are using it as stores of wealth for their balance sheets. Imagine if the US dollar was half as valuable a week from now and the damage that would cause.
I Don’t Own BTC So Who Cares?
Well we all do now. Between your retirement account and regular investment account you are almost guaranteed to own the S&P 500. Now that Tesla has bought Bitcoin you have exposure to it if you own the S&P. Sure, their 1.5B Bitcoin purchase is not going to drastically affect the entire index but what if more of those companies see them making money off it and follow their lead? The risk is that the balance sheets of these companies may appear safe when in fact they are built on a house of cards. Combine that with the increasing amounts of money that investors are pouring into Bitcoin. Suddenly, your exposure is everywhere. This brings us to a situation eerily similar to the early 2000’s……
What Does Bitcoin Have to Do with The Great Recession?
Back then, the crisis centered around mortgage backed securities (MBS).
Mortgage Backed Securities
MBS are essentially bonds that contain multiple mortgages in one security. This acts like a bond because the owner of the MBS receives mortgage payments in the same way the owner of a bond receives payments on debt. Because there were multiple mortgages bundled into one MBS, these securities were deemed especially safe. One failure to repay could not take down the whole security.
Overtime, pensions, hedge funds and individuals began to stock up on these new securities. Banks made money selling their mortgages to hedge funds and other banks that created MBS. They began to give mortgages to people who couldn’t really afford them so they could have more mortgages to sell.
Everyone upstream thought they had safe assets without having any way to value or understand these securities. As long as the housing market increased their securities and the homeowners below them would continue to be okay. Obviously, when the housing market lost steam and interest rates increased (making mortgages more expensive for people who couldn’t really afford them) this all came crashing down. Those multiple loans in one security were all bad so there really was no safety from the fallout.
The mechanics of MBS compared to Bitcoin are obviously different. But the broad takeaway is the same.
Here was a hot new type of unregulated investment that people were making tons of money on. As it’s bullish run continued it began to become viewed as more safe. This perception allowed it to permeate throughout the financial world until it formed a substantial part of the wealth of everyone. The lack of regulation allowed an insanely profitable bullish run but it also allowed it to disappear overnight. This is what can happen when market forces are not regulated.
So What’s Next?
Will Bitcoin cause the next bubble? I don’t know anymore than you. And I sure as hell won’t put myself out there and become the next article like the ones in January 2020 that had no idea of the 800lb gorilla in the room.
I do think as an investor you need to question everything. And I think an important question we should be asking is what is the future of bitcoin? Increasingly, the answer is going to affect all of us.
For the record, I think Bitcoin is an awesome idea. I’m a fan but I don’t know where this goes from here. I think one the best ways we can prepare as investors is to study the past. To understand bubbles the absolute best book is Big Debt Crises by Ray Dalio. He covers tons of crises throughout history and makes them easy to understand. He also made money in 2009 when everyone lost it because he was able to see it coming. If you want to be a better investor and understand where we might be headed, reading this book will get you there a lot faster than the news.
Thoughts on Bitcoin? We’d love to hear them.