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Last week, bitcoin hit a new high, topping $112,000 for the first time. Over the past 12 months, it’s gained an impressive 55%. What’s driving these gains, and what should you make of it? There are, in my view, three key factors. Two are new. One is not. First was a policy change last year: The federal government approved the launch of new exchange-traded funds (ETFs) that offer easier and more direct access to bitcoin. Following this rule change, 11 new bitcoin ETFs launched in quick succession. These new funds have collected more than $100 billion in assets, helping to drive up the price—and thus the interest level—in bitcoin. Also helping has been the Trump administration’s friendlier posture toward cryptocurrency. The president has declared his intention to become the “crypto president” and has issued executive orders loosening restrictions on crypto firms. There is now a “crypto czar” in the White House, and the administration has discussed the idea of funding a strategic bitcoin reserve akin to Fort Knox. A third factor, though, may be the most powerful driver of bitcoin’s gains, and that’s the reality—justified or not—that asset prices tend to go up when other people think they’re going to go up. While this might sound circular, it’s a well understood concept in economics and was first articulated by John Maynard Keynes in his 1936 book, The General Theory of Employment, Interest and Money. Keynes compared the stock market to what he called a “reverse beauty pageant.” Investors, he said, were no longer looking to choose the most attractive investments. Instead, “we devote our intelligences to anticipating what average opinion expects the average opinion to be.” Investors, in other words, want to buy what they think other people will want to buy, regardless of the investment merits. Using that yardstick, bitcoin looks eminently appealing right now. In addition to its most recent runup, it’s delivered a more than 1,000% gain over the past five years. It’s clearly what other people want to buy. To a degree, investors’ attitude toward bitcoin is rational. There’s a concept known as “rational ignorance” that helps explain some of the enthusiasm. According to this theory, there’s simply too much going on in the world for any one person to be able to follow. So we rely on the opinions of others to help fill in knowledge for us. If someone else has done the research and reached a conclusion on a particular topic, then it only makes sense for others to piggyback on their efforts. This can be helpful, but the fly in the ointment is that this same channel can help investment bubbles to inflate. A related concept also helps explain the rise of bitcoin: It’s what author Chimamanda Adichie refers to as a “single story.” Whenever there’s a simple, easy-to-understand story associated with an idea, that will help it to spread. Bitcoin has several compelling stories attached to it. There’s the idea that, unlike traditional currencies, it’s independent of any government’s control. And there’s the fact that its total supply is structurally limited to 21 million coins, making it resistant to inflation. There’s also mystery surrounding its creator, who used the pseudonym Satoshi Nakamoto but has never been identified. No one has ever even claimed to know someone who knows him. All of this, I think, helps to explain much of bitcoin’s popularity. No one really knows where it will go in the future, but because it seems like it’s going somewhere, that induces more people to get on board. And the cycle accelerates. In fairness, investors have been taught to believe in markets and to trust market prices. This is the cornerstone of the efficient market hypothesis (EMH). This theory—which helped economist Eugene Fama win the Nobel Prize—argues that asset prices are always “correct” because they reflect all available information. According to the EMH, if bitcoin is trading at $112,000, then that must be the right price, because it reflects the collective wisdom of millions of investors everywhere. This notion, that prices are “informationally efficient,” goes back at least to the early-1900s, when a fellow named Francis Galton conducted an experiment at a livestock exhibition. He set up a lottery, asking contestants to guess the weight of an ox on display. He collected 787 votes then compared the average to the actual weight of the animal. The crowd was remarkably accurate: The average guess was 1,207 pounds, while the actual weight of the animal was 1,198 pounds. Galton dubbed this vox populi—the voice of the people. More recently, author James Surowiecki took a closer look at this phenomenon in a book titled The Wisdom of Crowds. He points out that crowds aren’t always accurate. Instead, four criteria are required for the vox populi to deliver a reliable answer:
This is where, in my opinion, there’s a flaw in the bitcoin story. Markets today generally fail the independence test. In the age of the Internet, opinions are rarely independent because investors all influence each other. Especially when it comes to something like bitcoin, that has turned people into millionaires and even billionaires, opinions are shared broadly and publicly. Services like Google Trends can quantify this. That constant, public discussion sits in contrast to the secret ballots cast at the livestock competition, where each contestant was making a strictly independent judgment. Hedge fund manager Clifford Asness has argued that this is a phenomenon that reaches beyond cryptocurrency. Because the Internet—and especially social media—have made communication so easy, he says, the collective investment judgement of crowds has gotten worse, not better. He calls this the “less-efficient market hypothesis.” Bitcoin’s gains might make it seem like it has a solid foundation, but in my view, it’s like a building being built on quicksand. A quick survey of bitcoin’s peers helps illustrate why. For starters, there are now thousands of different coins. One online tutorial describes how easy it is to create a new crypto coin. That’s why creations like the TRUMP coin, launched just before Inauguration Day in January, have achieved market capitalizations in excess of $2 billion. If coins like this can be created out of thin air and gain millions or billions in value, there’s no reason to see bitcoin as being less of a mirage than its more obviously comical brethren. The only reason bitcoin carries more legitimacy, in my view, is simply because it was first. But as economist Owen Lamont has pointed out, that doesn’t mean it has value that’s more tangible than other crypto creations. “We buy bitcoin because we believe others will buy it in the future,” he says. It’s the “Kardashian of money”—famous only because it’s famous. In his book Narrative Economics, Robert Shiller puts it this way: “People are interested in bitcoin precisely because so many other people are interested in it.” It’s for this reason that I recommend standing clear of the frenzy. Unlike real investments, such as stocks or bonds or real estate, which carry intrinsic value—that is, the ability to generate income—bitcoin has nothing tangible supporting its value. Its only value derives from the fact that it’s popular. But as tulip investors learned the hard way in the spring of 1637, sentiment can shift quickly. |
