“How do we know when irrational exuberance has unduly escalated asset values?” – Alan Greenspan
Recently I made a small wager with a colleague of mine. Similarly to the cryptocurrency market, it was irrational, bold, and excluded basic fundamentals.
The bet? The total cryptocurrency market capitalization will surpass $1 trillion USD before January 1, 2019. As of this writing, the crypto market cap is only around $150 billion. I suspect it would be challenging to find a rational person that wouldn’t take the other end of that bet!
But here’s why I might be right:
Lately, I’ve been fascinated by market cycles and analyzing previous bubbles. What became clear to me was that investor psychology of fear and greed remained the same across various asset classes and markets. Cryptocurrencies are no exception. With technological innovation often comes irrational exuberance. The most notable (and recent) example was the introduction of the Internet to the masses. While the Internet did, in fact, disrupt every single industry, investors in the late 90’s significantly exaggerated the extent of the improvement in economic fundamentals. In other words, investors placed massive, unjustifiable premiums on Internet companies while disregarding basic fundamentals like sales, profitability, and growth. The Internet wasn’t perfect by any means but it represented a world of endless possibilities. This excitement ultimately led to the “dot-com” bubble.
“It happens again and again in history, when markets have been bid up to unusually high and unsustainable levels under the influence of market psychology” – Robert Shiller
When we look at the emergence of cryptocurrencies, it also provides the market with a similar sentiment. This idea of a decentralized economy, trustless systems, and bringing capitalism to open-source projects is attractive because it’s a completely new way of doing things. In some ways, I believe it will fundamentally change the way we conduct business and just like the Internet, it has the ability to disrupt almost every industry either directly or indirectly. In a matter of months, we saw the total cryptocurrency market cap explode from almost $18 billion at the beginning of the year to a high of $180 billion! There’s no question we have seen an exuberant runup that makes it easy to scream “BUBBLE!”
Source: CoinMarketCap (CMC)
Peak Dot-Com Bubble
When I look at the dot-com bubble in particular, what surprised me was how short it actually turned out to be. The best estimates I could find were over a 5-year period. It’s incredible to think about the speed at which a new and exciting technology can take the market by storm and create a massive, speculative bubble. I would argue that because of the speed at which content is created and information is consumed, the cryptocurrency market will hit peak hype cycle significantly faster than the dot-com bubble did. In other words, the extent to which cryptocurrencies will spread among friends, along with popular news outlets, will be more drastic than in the late 1990’s.
If you search for any crypto-related news, you will most likely find a lot of articles on “hot” ICO’s or Initial Coin Offerings. You can think of ICO’s as Initial Public Offerings (IPO’s) but for tokens/coins rather than equity. And truthfully, the vast majority of these ICO’s are outright scams. When I think about ICO’s in this regard, it’s hard not to think about the numerous IPO’s in the late 90’s that were effectively vaporware as well. Here are some interesting IPO stats for you to snack on. IPO’s accounted for $1 billion in 1997, $2 billion in 1998, and, $24 billion in 1999!
As of 2017, ICO’s have raised just north of $2.5 billion with no signs of slowing down! While ICO’s and IPO’s have their fair share of differences, the exuberance we have seen in this new fundraising vehicle is incredibly similar to the IPO craze in the late 90’s. Like investors back then, we are seeing a new wave of investors ignoring basic fundamentals in hope of making a quick return. Even if you want to argue that comparing cryptocurrencies with the dot-com bubble isn’t a fair matchup, it’s hard to deny the similarities in investor psychology.
Regulations & Institutional Investors
So let’s get one thing right: we’re definitely in a bubble. The question now turns to how inflated does this get. I believe the answer to that question has to deal with institutional investors. When I look at investment intermediaries, it’s clear that they are looking for returns that can make up for their relatively lackluster performance over the past few years. While I anticipate traditional hedge funds and money managers to dedicate a small portion of their overall portfolios to digital assets, we have already seen a surge in the number of crypto-only hedge funds:
- Polychain Capital – $200 million in assets under management, with investment from Andreessen Horowitz, Founders Fund, Sequoia Capital and Union Square Ventures.
- Metastable Capital – $45 million in assets under management, founded by Lucas Ryan, John Seims and Naval Ravikant, CEO & Co-Founder of AngelList.
- Mike Novogratz – $500 million cryptocurrency hedge fund where Novogratz is putting up $150 million of his own money and is expected to close on $350 million by the end of this year.
While these funds may be small by industry standards, they are among 50+ dedicated hedge funds focused on digital assets in a small $150 billion market. Each month a new and bigger fund is being launched to jump on the wagon and it’s becoming more clear that we are entering the institutional investment phase in the crypto adoption lifecycle.
As institutional investors get involved, we will see more stringent regulations in what has been known as the “wild west” of investing. People in this space are well aware of China’s temporary bans on ICO’s and Bitcoin exchanges but what’s most interesting to me is the SEC’s involvement. Recently, the SEC charged a “businessman” and two companies with defrauding investors in a pair of ICO’s. They ARE monitoring the market and ARE actively seeking ways to establish a regulatory framework that doesn’t hinder innovation. So while concerns around the regulatory environment have caused some serious heartburn for some, I would argue that regulation will legitimize the crypto market for institutional investors. Consequently, a regulated ICO market with the appropriate checks in place will ensure a safer market that instills confidence amongst all market participants.
While $1 trillion by the end of 2018 seems like a stretch, we did see the total crypto market cap 10x to just under $180 billion in only 9 months. Where will the next 10x come from? With Goldman Sachs and other top-tier banks considering new trading operations dedicated to bitcoin and other digital currencies, my money is on institutional investors. Whether that’s in the form of new financial instruments such as derivatives or ETF’s or just making it easier and safer to buy and sell cryptocurrencies, the impact this can have on the market is nothing short of significant.
At the end of the day, I don’t mind if I’m right or wrong on timing (I’d suspect the length is ambitious) but the similarities are clear. We are seeing the emergence of a massive bubble. Everything leads me to believe we are just getting started. And just remember: “Anytime a new industry emerges, many turtles hatch, few make it to the sea.” Since it’s always easier to be on the other side when passing judgment, this is my justification for why I’m not completely crazy!
There are TONS of reasons why I could very well be wrong. Some of these reasons include, but are not limited to:
- A regulatory environment that: (1) significantly slows down the rate of adoption (i.e., continuing/widespread ban of centralized exchanges that serve as an on-ramp to cryptocurrencies) and/or (2) bans ICO’s.
- I am overestimating the likelihood that institutional investors will pour into the market next year at a rate we haven’t seen before.
- We enter a recession and see a sharp decline in asset values across the board. I don’t think this will lead to increased demand for cryptocurrencies (while others may disagree). I believe when people need to pay the bills, that money will come from existing investments which will further depress prices.