If we as investors looks back 10, 20, 50, or even 100 years, we'd have a hard time finding an asset with a more consistent long-term return than stocks. Every single commodity, and even housing-price inflation, takes a clear back seat to the 7% annual gains seen in the stock market over the long term, with the assistance of dividend reinvestment.
But 2017 has been a completely different beast. Virtual currencies like bitcoin and Ethereum have stolen all the glory, and with good reason. Through Nov. 13, bitcoin was up more than 560% since the year began, while Ethereum, the second-largest cryptocurrency by market cap, had jumped by nearly 3,850% in roughly 10 1/2 months. These are gains often generated over decades or during a lifetime that digital currencies have delivered for investors in less than a year.
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What's fueling these enormous returns in cryptocurrencies?
A mixture of tangible and emotional catalysts appear to be responsible for a good portion of cryptocurrency gains this year.
For example, investors are clearly excited about the potential for blockchain, the digital and decentralized ledger that records transactions without the need for a financial intermediary like a bank. Blockchain is what underlies most virtual currencies, including bitcoin and Ethereum, and it's believed to be the future of peer-to-peer and business-to-business transactions given its security. Because blockchain is usually open source, it means that changing logged data without being spotted by someone else within the network would be practically impossible.
Blockchain has also gotten a boost from the willingness of some brand-name businesses to test out the technology in small-scale and pilot projects. The Enterprise Ethereum Alliance has in excess of 150 organization testing out a version of Ethereum's blockchain, while bitcoin's soft fork this past summer into two separate currencies, bitcoin and bitcoin cash, saw the former implement capacity upgrades to its blockchain with the expressed intent of attracting enterprise customers.
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The falling U.S. dollar is another positive for digital currencies. Weakness in the U.S. dollar usually sends investors holding cash to different assets that will be a better store of value. Traditionally, this has been gold's domain, given its relative scarcity and the fact that it's been used as a form of currency for centuries. However, because bitcoin has protocols limiting the number of mined coins to 21 million, it, too, is viewed as a finite resource and a store of value.
Emotional factors, such as not wanting to miss the boat following massive gains, is another reason these virtual currencies have flourished. Given that institutional investors have mostly shied away from investing in bitcoin and/or Ethereum, it's the highly emotional retail investor that's been responsible for setting the price of cryptocurrencies.
A good year, but far from perfect
While there's little arguing that it's been a great year for bitcoin, the largest cryptocurrency by market cap, it's been far from perfect. In fact, those with a weak stomach may have lost their lunch more than once riding the bitcoin roller coaster since June.
According to data from Bloomberg, bitcoin has had three major corrections over the past five months, all of which would have qualified the virtual currency as being in bear-market territory.
Over the course of a month between roughly mid-June and mid-July, bitcoin lost 38% of its value. The drop was a result of concerns about the aforementioned soft fork that saw bitcoin split into two separate virtual currencies at the beginning of August. Before mid-June, investors believed a consensus would be reached regarding the future of bitcoin's blockchain that would avoid such a split. However, the required 80% consensus was never reached, resulting in the soft fork that saw bitcoin upgrade capacity by taking some information off its blockchain, and bitcoin cash expand within the existing blockchain framework.
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In the span of just a few short weeks in early to-mid September, bitcoin shed 40% of its value following worrisome news out of China. The country that had been a cryptocurrency mining mecca announced that it would be halting all initial coin offerings, calling them breeding grounds for fraud. South Korea soon followed with a similar measure. China noted that it planned to shut down domestic cryptocurrency exchanges, too. This obviously didn't sit well with bitcoin investors.
Lastly, over the past week we've seen bitcoin shed as much as 29% of its value after the SegWit2x upgrade was abandoned. Similar to the June/July shenanigans, bitcoin investors believed a consensus would be reached regarding the future of its blockchain, and it was not, thus canceling the SegWit2x upgrade for bitcoin.
This volatility is something bitcoin investors have almost become accustomed to dealing with.
Things may be about to get tougher for bitcoin
Despite these major corrections, optimism surrounding bitcoin remains high. By year's end, bitcoin's official listing on the CME Group's (CME +0.53%) futures trading platform is expected to improve liquidity, introduce new money by allowing institutional investors to take a stake, and lower the volatility of this retail investor-driven asset.
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But it could actually have the opposite effect. The introduction of futures will allow investors the ability to bet against bitcoin for the first time ever, which could mean even greater downside risk. Bitcoin pessimists have been eagerly waiting for an opportunity to bet against bitcoin, which is why CME Group has pushed so hard to list bitcoin futures by the end of the year. CME Group should be a winner either way, but I can't say the same thing for bitcoin's investors.
Increased regulations surrounding bitcoin aren't necessarily a win, either. While regulating bitcoin does help validate it as a currency, regulations from the likes of China can just as easily push it out of lucrative markets.
There's also that major concern of whether people really understand what they're investing in. The true value of bitcoin rests with its blockchain, with very little worth being tied to its virtual currency. My suspicion is that novice cryptocurrency investors aren't aware of this and are focusing on the payment potential rather than blockchain platform as the true source of value. That could be a major mistake, especially with bitcoin's blockchain potentially less desirable than Ethereum's blockchain with built-in smart contracts.
Though bitcoin's investors have survived downward swings before and come out no worse for wear, I don't believe this is a trend that can continue over the long run.
