The Reality All Bitcoin and Ethereum Investors Need to Come to Terms With
History suggests cryptocurrencies are likely in a bubble.
Historically, there have been few if any assets that have trumped the stock market in terms of average returns. Inclusive of dividend reinvestment, the stock market has generated 7% returns over the long run, which works out to a doubling of your invested wealth about once a decade. But in 2017, cryptocurrency returns have blown the stock market out of the water.
Through Monday, Oct. 16, bitcoin, the most popular digital currency and the largest by market cap, had gained nearly 500% year to date. Ethereum, which is the second largest cryptocurrency by market cap, was up an even more impressive 4,100% since the year began. As a whole, the aggregate market cap of more than 1,100 tradable cryptocurrencies now sits at $172.2 billion, up 876% since the beginning of the year. For comparison, it's taken more than two decades for the broad-based S&P 500 to deliver similar returns.
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Fact the facts: Investors overestimate the potential of new technologies, goods, and services
While most investors in bitcoin and ethereum are wondering just how high these coins could fly, there's a reality that they also need to come to terms with, and one they're probably not going to like: Investors have a long-running habit of overestimating the potential of any new technology, product, or service. We can look back two years, two decades, or even centuries, and find instances of investors vastly overpaying for an asset that was unproven at the time.
In recent years, we've seen this overzealousness manifest in the 3D-printing industry. Companies such as 3D Systems (NYSE:DDD) were expected to revolutionize the prototyping and manufacturing industry with machines capable of fulfilling businesses wildest CAD/CAM dreams. It was also expected that consumers would have growing interest in 3D-printing applications, which enticed 3D Systems to develop the Cube 3D printer for consumers. Unfortunately, interest in personal 3D printers never took off, and businesses became saturated to the point that demand dropped. Despite seeing its share price rally from $2 to nearly $100 in just a few years, 3D Systems reversed course all the way back to $8 a share as of January 2016.
Two decades ago, the buzz was all about mapping the human genome and what sort of amazing discoveries drug developers would make once personalized medicine became the norm. Celera Corporation, which has since been acquired, was a big name back in the late 1990s in mapping the genome. Entering the space later than some of its peers, it was able to take advantage of what genome-mapping data was already available, which was believed to have given it a cost advantage. Between going public in May 1999 and February 2000, its share price rocketed from $15.25 to an intraday high of $321. Eventually, Celera was acquired for essentially the same amount it launched at in May 1999, meaning it gave up all of its gains.
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Nearly 400 years ago, history tells us that consumers and investors in Europe went crazy over the introduction of the tulip. Quickly becoming a hot luxury item, tulip bulb prices rose to a peak of 10 times the annual income of a skilled craftsworker as of early 1637. Mind you, that was the price for a single bulb. The parabolic rise and tumultuous tumble of tulip bulbs took place over just seven months.
These are just some of the countless instances throughout history of overestimating the potential of a new technology, product, or service, and there's no reason to believe that bitcoin and ethereum will end differently.
Take a gander at the Bitcoin Investment Trust (OTC:GBTC), which is an ETF run by Grayscale that does nothing more than hold a relatively fixed amount of bitcoin, and charges its shareholders an exorbitant 2% annual management fee to do so. As of the end of September, the Bitcoin investment Trust held 172,437 coins, which as of Oct. 16 are worth $986.5 million. Yet the Trust has a net asset value of $1.12 billion. This premium was actually north of 100% a few months ago, and it represents just how out of touch with reality investors are when it comes to valuing cryptocurrencies.
Tangible worries for bitcoin and ethereum
The truth is, investors to have tangible reasons to be concerned with the value assigned to bitcoin and ethereum.
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To begin with, investors may be placing far too much emphasis on bitcoin and ethereum as payment platforms, rather than focusing on their underlying blockchain technology, which is where the value for these digital currencies really lies. Ethereum isn't accepted as payment by any major retailer at the moment, while bitcoin has a handful of brand-name companies that've accepted it since 2014. However, if you were to try to live off bitcoin at the moment, you'd struggle to do so. The high volatility of bitcoin, along with the length of time it takes for transactions to settle, is a deterrent to attracting new merchants.
Along those same lines, while blockchain technology is one of the many reasons cryptocurrencies are rallying, it's as of yet highly unproven. These digital and decentralized ledgers that record transactions without the need for a financial intermediary may be the secure payment platform of the future, but they're only being tested out in pilot and small-scale programs at the moment. There's also no guarantee that bitcoin or ethereum has the blockchain technology that businesses will prefer. Since the barrier to entry in developing this technology is so low, companies could easily utilize their financial resources to create their own versions of blockchain.
Regulation is another serious concern. Although government regulation would, in a way, provide some validity to bitcoin and/or ethereum as a legitimate form of currency, it could also be a means to remove market opportunities. The recent announcements from China and South Korea that they'd be shutting down initial coin offerings is one such example of how regulations can work against cryptocurrencies.
If history repeats itself once more, it'll just be a matter of time before the cryptocurrency bubble bursts and investors are left wondering what happened.