Time to Call it a Bubble

Hindsight is a beautiful thing. I love to see Monday night quarterbacks giving their expert opinions, after the fact. Bubbles are very easy to spot… after they burst! And after the pop, everybody will comment on how obvious it had become.

Anybody who traded the markets in 1999 would remember the dot-com bubble. The time when anything and everything ending in .com would attract outrageous sums of money. At one point, a client of mine, asked me, in no uncertain, terms to invest his money in any company whose CEO appeared on CNBC wearing a turtleneck. I won’t depress you with the outcome of that story.

One thing about bubbles, is they can make even the smartest investors lose their discipline. It happened in the dot-com bubble with people investing in webpages that offered no way of monetizing content, or had no business plan for that matter; it happened to people shorting the market in the housing bubble, where they started longing certain CDOs in order to generate enough cash flow to sustain their short positions; it happened to railroad investors in the 1800s, and it happened to tulip investors in the 1600s.

Today’s bubble is called crypto-currency. It has several similarities to the dot-com bubble:

1. Nobody knows how to value them. This was true in 1999 as it is now. How did an investor value a website in 1999? It made no money, it produced nothing, sold nothing, posted no earnings, had no projected earnings. It was impossible to value using any of the generally accepted valuation methods learned at business school. So what did people do? They bought anything and everything ending in dot-com… because it was going up. Today it’s no different. How do you value a crypto-currency? I, for starters, don’t have the faintest clue, and I’m not embarrassed to admit it. I guarantee you I am not the only one out there. You can’t value it like an asset, since it generates no cash-flow; you can’t value it as a currency, because it has no backing from a government, and you can’t use proxies like GDP, trade balance, or compare it to different currencies using interest rate parity or purchasing power parity; you can’t value it as a commodity, because it has no usefulness in the productive cycle, and thus has no supply and demand.  It has no intrinsic value, all there is, is speculation.
2. Nobody knows how they work. Back in 1999, almost all businesses had a website, but the concept of a website that was the business, was something of a novelty. And while everybody enjoyed a nice website, nobody really understood how a business could be generated from it. Today I bet nobody truly understands what crypto-currencies are. Are they a currency or are they an investment? Are they used as legal tender or as a medium to accumulate wealth? By definition, these concepts are non-compatible. You are either one or the other, and people really don’t seem to agree on what exactly they are and therefore what behavior to expect from them.
3. Everybody and their brother are buying it. In the first few months of 2000, fueled by the formidable returns of 1999 there was a massive rush of retail investors into the dot-com bubble.  You couldn’t swing a dead cat without hitting someone investing in dot-com related stocks.  I remember at the time, our shoe-shiner (a kid that used to come by the office twice a week and shine our shoes while we were glued to our screens), told me he had saved $50 in tips, and wanted to know how to buy stocks.  Today, it’s no different: The major crypto-currency exchanges have been consistently adding over 100,000 new users every day for the last two months.  If this is not a bubble, what is?
4. Mass hysteria. In 1999 anything.com would have millions thrown at them, and not only by J.Q. Investor, but by some very smart VC firms.  Ask for funding to run a pet store? you’d have been shown the door. Ask for backing for pets.com and you raised a fortune.  Last month I witnessed the first signs that there is mass hysteria in the crypto-currency bubble.  The Long Island Iced Tea Corp (NASDAQ: LTEA), renamed itself as Long Blockchain Corp (NASDAQ:LBCC), the stock rose 289% as a consequence.  Earlier this week Eastman Kodak (NYSE: KODK) doubled in price when it announced it would start using blockchain (the underlying technology in crypto-currencies).

“Never invest in a business you cannot understand” – Warren Buffett

Having said that, here are a few pointers for those trying to get into the crypto-currency bandwagon.

1. Don’t invest in anything you don’t understand. Paraphrasing Warren Buffett: “Never invest in a business you cannot understand”.  If the market tanks, you won’t be able to assess the situation and understand if it is mere speculation, or if the value has disappeared and it’s time to move on.
2. The last guys in are the first to get nailed when the bubble bursts.  The big money went in early, and even during the first few days after the bubble pops, they can still get out making some money.  The investors who got in at the top have nothing but losses to face.
3. You can only sell if there is someone buying.  You can have all the stop-losses you want, and have most sophisticated trading programs available, but if there are no buyers, you can’t sell.
4. You only make money once you close your positions.  Unrealized profits are useless, so if you are a Bitcoin billionaire, make sure you realize that profit, before all you are left with are tales to regale your grandchildren with.

So, what about shorting?

For some time I’ve been looking at ways to short Bitcoin, and when futures finally went live, I got too scared to do anything in that area.  You see, if you buy Bitcoin, and it goes to zero, your maximum loss is 100%, but your potential profits are, in theory, unlimited.  When you short it, the maximum you can make is 100%, while your losses are unlimited.  Compound this by the leverage associated with futures, and you have a nuclear bomb at your desk.

Another problem with shorting is that you have to time the market correctly.  As absurd as the current prices of Bitcoin are, nobody knows if we are at the end of the bubble, or if it can take some more hot air.  If the latter, you may be faced with prohibitive margin calls that would render your investment useless, or force you to close the positions ahead of time, missing the downside.

Conclusion: Stay away from crypto-currencies until the bubble bursts, and the dust settles.  Only then you can pick from the survivors that have the best business model.  The underlying technology has several applications in the business world, but applications nonetheless, not businesses.  I have yet to understand how can blockchain become a business in its own right.

In case you missed it, here is a link to last week’s post: Does the Bull Have Legs?