AJ Bell press comment – 14 November 2022
- Bitcoin down by only 8% in the past week, despite FTX’s collapse
- Leading cryptocurrency has lost three-quarters of its value from the peak a year ago
- String of scandals in the asset class in keeping with Kindleberger’s model of bubbles (and how they burst)
“The collapse of cryptocurrency exchange FTX is the latest in a growing line of accidents to befall the crypto ecosystem, after the downfall of Luna, the Three Arrows hedge fund’s failure, the bankruptcy of broker Voyager and demise of lender Celsius,” says AJ Bell Investment Director Russ Mould. “FTX’s implosion will be particular test of faith for crypto enthusiasts and, under the circumstances, you could argue that Bitcoin is holding up relatively well at just shy of $17,000 given the torrent of bad news. The question now is whether there are further shocks and scandals to follow.
“Bitcoin has slipped by around 8% over the past week. But it could surely have been a lot worse, given how the fall from grace of the second-biggest crypto exchange was at least partly provoked by a loss of confidence in them by the largest player, Binance, which dashed to withdraw its assets, and how FTX’s founder Sam Bankman-Fried then tried to prop up his crypto empire with the very stuff his tokens were supposed to replace, namely fiat currency (old-fashioned dollars).
“It is also tempting to expect further drops in speculative assets such as Bitcoin and cryptos if the Fed and other central banks continue to tighten monetary policy. As interest rates rise, and Quantitative Easing is being (slowly) withdrawn, the cost of money, and returns on cash, are going up. This may tempt investors to treat money with more reverence and take less risk.
“Indeed, some investors may argue that since central bank largesse blew bubbles in everything from equities to bonds, property, art, wine, sports cars, thoroughbred racehorses and cryptocurrencies, then the withdrawal of that cheap cash will pop the selfsame bubbles.
“Even if Bitcoin has fallen less than some may have expected in the past week, it has still lost two-thirds of its value in 2022 and three-quarters since its all-time high a year ago.
Source: Refinitiv data
“If this is indeed a bubble that has gone pop, then investors will be wondering if all of the bad news is in the price and whether it is time to go against the crowd and get involved just as long-term bulls are losing faith.
“One useful guide here could be, Charles P. Kindleberger’s magisterial study of financial bubbles Manias, Panics & Crashes. It establishes a fairly typical sequence of events that can be seen through the history of previous market crazes, ranging from the South Sea Bubble of 1720 through to British canals (1790s), Latin American mines (1820s), US equities (1920s), Japanese equities and property (1980s) and global technology stocks (1990s), to name but a few.
“Looking at the patterns of past bubbles may help investors duck the next disaster which will, inevitably, unfold at some stage. This is because the details may change from bubble to bubble, but human behaviour clearly does not and the running order is pretty consistent:
- The starting point for a bubble is a new investment opportunity, one that may be genuine, or even one with just a big enough grain of truth to be irresistible to those looking for a quick financial killing. It could be anything from railways to cryptocurrencies and the more disruptive or revolutionary it seems, the better, as everyone likes to get in on a ‘new paradigm,’ don’t they?
- Initial price rises then catch the attention of newcomers, as ‘fear of missing out’ (FOMO) starts to gather.
- Investing (and operational) profits go into orbit and fresh cash is attracted, often in the form of borrowed cash.
- More copy-cats and imitators spring up and more credit is made available as asset prices keep running and the profits keep flowing.
- Then the trouble starts. Insiders start to lock in their profits by selling to the unwary at elevated prices and leave investors holding the bag. Prices initially correct but then rally as loyal supporters ‘buy on the dips.’
- Initial signs of distress then start to sow real seeds of doubt. A new offering goes wrong, a firm runs out of cash and asset prices fail to reach their previous peaks. The queue of copy-cat flotations and management teams looking to sell their stock on a secondary basis gets longer by the minute and supply of paper begins to outstrip demand.
- Then comes a good, old-fashioned scandal. Someone goes bust or accounts prove to be crooked, or someone runs off with the money and investors realize they have been had.
- Fear and revulsion replace greed, asset prices collapse as investors scramble to cut their losses and the recriminations begin as scapegoats are sought and publicly pilloried (or worse).
“Investors can judge for themselves where they feel cryptocurrencies stand in this cycle (assuming they accept the view the cryptos did indeed enter bubble territory in the first place), but if Kindleberger’s model holds firm, there could be more bad news to come, especially if central banks stay the course, and keep hiking rates, to take away at least a chunk of the cheap liquidity that did so much to fuel interest in crypto in the first place.”
