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How can we better understand what "Financial Bubble" means.

December 23, 2017

 

In recent months, we have been hearing more and more about financial bubble

Actually, a few years ago there was talk of a bubble on the bond markets, the newspapers spoke of it, both financial and non-financial, the specialized television stations and the phantom macroeconomists all over the world spoke of it.

 

COUNTERINTUITIVE

It is true, it is illogical in financial terms to have to pay to lend money to someone, even if it is a state; We are experiencing an absurd never-ending success in the world of financial markets, mainly due to the enormous liquidity injected into the markets by the central banks that are well financed through the banks coffers to avoid bankruptcy and these, which are typically cautious, have carefully considered to transfer them to the states (in turn making it difficult).

On the other hand, if I am not mistaken, Keynes who is the author of the famous phrase:"the financial markets can remain irrational much longer than you can remain creditworthy".

 

BENEFITS

In reality, this absurdity has made impossible for the financial system to fail, so it is welcome, even if, on the contrary, it obviously fosters irrational phenomena such as the bond markets with negative returns (and therefore meaningless bond prices), the stock markets are affected (not all but most of them) new peaks day after day.

 

OTHER BUBBLES?

A phenomenon that is not actually fostered by the money of the central bank and all are labeled as a meaningless mega bubble such as Bitcoin and the cryptocurrencies phenomenon.

Is the price of Bitcoin bubbled? Does it make sense to quote more than $10,000? is it too high or can it reach $25,000?

As always we will try to handle the problem in the most analytical way possible.

 

Let's start with a graph:

What type of security (financial instrument) does it represent? The Bitcoin? what does it look like?

 

Well, no, it is a Nasdaq company in the New Economy years, especially the CMGI Venture Capital fund, which at the time invested in many Nasdaq technological companies.

 

CRAZY

I remember that in 1999 I used it as an example because someone had invested $1000 in that stock in 1996 and at the end of 1999 had $1.000.000 which was a return never seen on the financial markets.

The growth of the graph doesn't seem so spectacular because it is logarithmic in scale, but in reality, it is a stock that has increased from $3 to almost $100 in less than three years in the graph.

But that's not all, the graph that I showed you before goes up to 1998, actually, the company has grown again, as shown in the next graph below:

From 100 it has gone up to a thousand in a relatively short time (less than two years) and this should make those who scream at the miracle ponder(or heresy) when you see the price of Bitcoin rise by 1000% in a year, so I thought it was interesting to compare the progress of bitcoin in recent years to this graph above:

 

INTERESTING, RIGHT?

It cannot be said that the graphs are the same, but that there is a similarity; to grasp it, it is necessary to use logarithmic graphs otherwise the linear scale graphs would make the initial values fall excessively.

But then we can affirm that since CMGI was a main stock of the bubble in the 2000s, will the Bitcoin be the bubble of 2017? or 2020? or 2025?

Who can assert this?

Then we need to resort to science and this time not statistically or financially, but science related to the forecasting of earthquakes.

 

A HELP FROM THE ACADEMY

You will think that I've gone crazy, but instead thanks to Prof. Didier Sornette, whom I had the pleasure to meet at the Global Derivates in Budapest in 2016, who works at the well known ETH, University of Zurich, in the department of physics for earthquakes, there is a lot of literature involved in the forecasting financial bubbles, with lots of mathematical models and practical examples that you can find on the ETH website.

One of the most obvious evidence of when a financial market is in a "bubble" is the exponential price growth, a phenomenon that I described in the post Why Bitcoin will rise even more in the coming months, which when it becomes unsustainable breaks out like a "bubble" of soap and "vaporizes" the savings of the most recent arrivals who will typically pay for all the others who have come out while making a profit.

 

HOW THE LOGARITMIC SCALE WORKS

To break it down into an understandable message, in a logarithmic graph like the previous one, the straight line represents exponential growth, so if the market grows faster than this straight line, it means that the market has more than an exponential growth, therefore it is unsustainable in the long term.

As it can be seen from the graph, nonetheless, the historical series of bitcoin in the first phase of its existence had an even higher growth rate than the current one, which suggests that in reality it is actually portraying a growth (although unbelievable in the rates of increase) which is, after all, sustainable.

 

CLARITY

Take note, this does not mean that I am claiming that a Bitcoin crisis is impossible and will not happen at all. I believe that sooner or later there will be a cryptocurrencies crisis that will cleanse the market from the many ICOs that have taken advantage of the moment to drain the liquidity of the system without a clear prospect of growth.

 

IT'S NOT ALL A JOKE

Here too, do not misunderstand me, there are companies that have collected a lot of money and that will probably become successful companies in the future, but like in the world of start-ups there has always been a very high mortality rate (I am certain of this, unfortunately...); however, there is no doubt that even twenty years ago, with the bubble of the New Economy, there were companies that took advantage of the moment to collect money that they would never have succeeded in collecting in any other way ( among many I will mention www.pets.com, a company that raised 150 million dollars as an e-commerce website for dogs and the payment services were not even active yet).

 

BUT LET'S RETURN TO THE BITCOIN, IS A BUBBLE OR NOT?

At this moment, the growth rate has returned to being slightly more than exponential, it is true, but it is sustained by a demographic growth of the users (still few) who are entering this world that are estimated at about 18 million, equal to just over 0.2% of the world population.

 

USERS (consumers)

I found out that the graphs related to the active wallets are struggling a little (which perhaps do not exactly correspond to the number of people because many, including me, have more than one wallet open and operational, but since it is very difficult to have the exact numbers and therefore some wallets may not have been included in the analysis, since we are estimating we will take it for granted.

This is the first graph on the demographic growth of users in the cryptocurrency world; in reality I have found another one that is estimating 18 million by November 2017 (while the graph above ends in the second quarter of 2017).

 

INCREDIBLE

I then tried to include the growth according to the number of wallets (always on a logarithmic scale) in comparison with the Bitcoin price and I discovered a very interesting connection:

The increase in price is very close to the growth rate of people entering the cryptocurrency world, which confirms my thesis in the post Why Bitcoin will rise even more in the coming months as long as there will always be new users entering the world of cryptocurrencies, the price is destined to rise.

For how long? and what will happen next?

Meanwhile, we can grasp something from the performance of the CMGI stock (which in the meantime has changed its name and skin and is now called ModusLink in the years after the outbreak of the New Economy bubble:

So just to clarify my personal stance, I think that Bitcoin has a high chance to rise even more (obviously with highs and lows which is characteristic of the historical series with high volatility), throughout that period the mutual funds and finance money will continue to come in bulk, until the point whereby a crisis with a strong drawdown will be very likely.

The strongest advocates of the cryptocurrencies will not believe me, but I can say that I too thought it will be impossible for banks to lose 95% of their value, just like the stocks of the new economy and yet it happened, so it can happen and it will also happen to the world of cryptos, not because it is fake (because it is not), not because it is false (because it is not), but because the world has always evolved through non-linear phenomena, as I explained in the post the Hyper Trend of the future.

When it comes to understanding the time and value at which Bitcoin will be at before having serious problems we are working on it, using Prof. Sornette's models to estimate when Bitcoin prices will increase so much that "surface tension can no longer hold the bubble together".

DB

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