Digital currencies such as bitcoin and ethereum have blown traditional investments out of the water since the year began. Bitcoin, which is the largest cryptocurrency by market cap, is up 373% year to date through Aug. 30, while ethereum, the second largest digital currency by market cap, has surged an almost unimaginable 4,737% year to date. For comparison, it's taken the S&P 500 more than four decades to return what ethereum has in a matter of eight months.
But the real story is just how much money has been poured into cryptocurrencies over the past eight months. Since the year began, the aggregate market cap of all cryptocurrencies has jumped from $17.7 billion to a record $161 billion as of Aug. 29 -- that's an 810% climb. Bitcoin, the kingpin of the group, and its recently spun-off bitcoin cash, are pretty much responsible for around half of those market-cap gains.
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Four reasons cryptocurrencies are up 810%, as a whole, year to date
What on Earth has the investment world going so crazy for digital currencies? Fundamentally, it has a lot do with the underlying blockchain technology that many of the largest market-cap cryptocurrencies use. Blockchain is a decentralized digital ledger that securely records transactions. Some pundits believe it could represent the future of peer-to-peer or business-to-business transactions. In fact, more than 150 organization, including some well-known businesses, are currently testing ethereum's blockchain on a pilot or small-scale basis. Ethereum appears best suited to appeal to big business, but the SegWit2X upgrade at bitcoin (bitcoin recently split into two currencies, bitcoin and bitcoin cash) should allow for faster processing times, lowering transaction fees, and greater capacity, which should appeal to enterprises.
Some investors simply like the idea of cryptocurrencies as a means of getting around traditional central bank-backed currency. In effect, bitcoin and other digital currencies act as a dream currency for libertarians. Quite a few well-known businesses also currently accept bitcoin to some capacity, adding validity that digital currencies may be here to stay.
We also can't overlook momentum. Since most financial institutions have been kept on the sidelines, this run higher in cryptocurrencies is almost entirely due to the expectations of retail investors. As long as someone is willing to pay more, emotions and lofty expectations could drive bitcoin, ethereum, and its peers, higher.
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Finally, look to the weakening U.S. dollar as a reason digital currencies are so strong. A weaker dollar is great for U.S. exports, but it's not so good for the American consumer or investor. Investors looking to maintain or grow their wealth may opt to move their money out of dollars and into a safe-haven commodity. Traditionally, gold has been this safe haven, but bitcoin and other cryptocurrencies have filled this role more recently. Gold is truly a finite commodity, but bitcoin's protocol also limits the number of coins that can be mined, giving it a "finite" feel as well.
Signs of a bubble are everywhere
Though these digital currencies have returned mouthwatering gains for investors, there's also the genuine possibility that this is a bubble just waiting to burst.
While arbitrary, this writer has seen an overwhelming number of cryptocurrency advertisements both online and in print suggesting that people invest in bitcoin. Generally, when we see an influx of ads surrounding a rapidly appreciating investment, it's often emblematic of a bubble. Some of the fastest appreciating investments, including marijuana stocks, have had their valuations crater not too long after the calls to "invest in marijuana stocks" ramped up over the past couple of years.
Second, there's not much in the way of "fundamental" data for investors to dig into to determine a fair valuation for cryptocurrencies. Without any government backing, there's virtually nothing to tether the movement of digital currencies to other than the short-term emotions of investors. Blockchain technology is still too new to really get a bead on its usefulness for enterprises, meaning today's cryptocurrency valuations may make little sense.
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There's also clear evidence of overvaluation apparent in bitcoin-based equities that stock market investors can buy. For example, the Bitcoin Investment Trust (GBTC -0.89%) owns 173,014 bitcoin, which are valued at $4,577 as of Aug. 30. On an aggregate basis, this means Bitcoin Investment Trust owns $791.9 million worth of bitcoin. However, the market cap of the ETF run by Grayscale was $1.55 billion by 3 p.m. ET on Aug 30. That's a 96% premium to what's actually owned within the ETF. This premium makes no sense whatsoever!
Just as maddening, First Bitcoin Capital Corp. (BITCF), which recently had its stock temporarily halted by the Securities and Exchange Commission for two weeks, is up over 24,000% over the trailing-12-month period. The company, which describes itself as developing cryptocurrencies, blockchain technology, and operating cryptocurrency exchanges, has virtually no assets, other than a mineral deposit in Venezuela from when it focused on being a gold mining company, and it generated a meager $46,236 in revenue in all of fiscal 2016. Yet First Bitcoin Capital has a market cap of $540 million. Wrap your hands around that.
I would strongly encourage investors who are seeking safe-haven assets to consider buying gold or silver to protect against a further decline in the dollar. Gold has a long history of being used as a viable currency, and it has a variety industrial and commercial uses. The same cannot be said for bitcoin, ethereum, or any digital currency.
