As I double down for my CFA exam this month, my posts have slowed down or become nonexistent. I plan to be back up at my regular pace by month end as I return to a more normal, yet still hectic schedule.
In the meantime, I couldn’t help but wade in on the current state of the crypto bubble. I have to admit, watching the prices go up on Ethereum this week did give me a fleeting sense of FOMO. Yet I remain on the sidelines when it comes to Bitcoin, Ethereum or any other crypto because I learned about bubbles long before I even started investing in the stock market.
As best described in this Slate article I was caught up as a child in the sports card bubble of the late 80’s and early 90’s. Just as market watchers keep an eye on the crypto market in lie today, in the 90’s we had the Beckett Price Guide which published monthly reports on thousands of different sports cards. As some dealers started to become wealthy and as institutional interest started to grow in sports cards as an asset class, you started to hear many of the same things you hear today: an alternative to stocks, an inflation hedge and a way for the little guy to compete with Wall St. Yet there was a very simple reason the price of sports cards collapsed in the early 2000’s: oversupply and the bursting of the tech bubble. There have been tons written on the over exuberance of the tech bubble and the subsequent dot com crash but the sports card bubble was also highly correlated with this crash and had an even more distinct driver behind its crash: overproduction.
There is an eery similarity to this and the crypto mania gripping many investors right now. In the mid 80’s, there were only a few sports card companies and although there were exceptions where rare cards had some value, most people didn’t consider these little pieces of cardboard anything of much value. Yet with the introduction of premium cards via the Upper Deck brand in 1989, the game changed. A number of sports cards companies crowded into the market and started to create tons of cards, flooding a multi billion dollar market with supply. They kept a tight lid on the number of cards they were producing but it didn’t take long until many people realized they were printing them in huge quantities and selling them at an absurd premium for a profit. This then caused the price of cards to collapse. The dot com bubble bursting turned investors off to alternative assets and within a few years, the market completely imploded. Now only 3 companies dominate the sports card industry. Each one is aligned with a specific sport after signing exclusive contracts. The industry is still a fraction of what it once was, hobbyists have moved on to things like NFT’s nowadays.
How Crypto Could Mimic This
There was real money to be made in sports cards then. The dealers and collectors who became rich were just making something out of thin air, there were real people who wanted to pay cash for these things, they found value in them.
This is the same situation with crypto today. There is real money to be made in the space and people are able to take advantage of it. Like any bubble however, it relies on the greater fool theory: that there will always be someone willing to take crypto off your hands for a higher price, or take it off your hands at all. You may think that Bitcoin and other crypto currencies have solved the oversupply problem by capping the amount produced. Yet there are reasons to think this won’t matter if investors were to run away from the asset class.
The first reason is that the lay people who hold crypto, not the programmers or die hard fanatics, probably couldn’t tell you the difference between the Ethereum, Bitcoin or Dogecoin. They are simply jumping on the next coin they hope will go up. The parallel to this in sports cards was the vintage or the year a card was made. For example Topps made a distinct line and design of card every year for all the players in baseball. Even if they overproduced the stock of cards in a particular year, there was still a finite limit to what was produced in any given year. There are only so many Topps Finest 1994 refractor rookie cards after all.
Yet people started to catch on that the insiders, in this case the card producing companies and those that worked there, were simply producing card inflation, which debased the value of cards as a whole. We can see a similar thing going on in crypto now. Bitcoin has reached above $50,000 yet the excitement seems to be fading a bit. Now people have moved on to cheaper currencies such as Ethereum and Dogecoin. Bitcoin’s price per coin may have turned some investors off who maybsinple just want to own a whole coin of something rather than a fraction.
In addition, you can look at each crypto coin like a vintage year in sports cards. Each one is unique but many more can come along. They essentially all follow the same blockchain standard but each has a bee gimmick. The ability to create a new coin for little to no cost contributes to overall or aggregate coin inflation. The potential supply of all crypto is theoretically infinite. So the argument that crypto is an inflation hedge is essentially a lie. One particular brand may be able to compare itself in supply to the amount of dollars or euros in the world but that only works if people still want to hold crypto in general.
Other Symptoms and Predictable Outcomes
You could expand this logic to other new asset classes as well. Non-Fungible Tokens or NFT’s don’t even give the owner copyright privileges and can be created out of thin air, yet money is pouring into these as speculators start to bid up their price.
The same can be said for SPAC’s, which have started to fade in popularity recently but were all the rage late last year.
Yet like all fads, the time for these assets will all come to an end. What is interesting is that while the US investing world is distracted with imaginary assets, real assets are gaining in value. The Vanguard Materials Index (VAW) is up 20.7% year to date and the SPDR Metals and Mining ETF (XME) is up 31.6% year to date.
As this recent article in the Wall St. Journal points out however, innovation in financial products usually gets overhyped and then becomes overpriced. Examples include the creation of closed end funds in the 1920’s, the invention and adoption of the internet in the 90’s and the innovation in structured products that occurred prior to the financial crisis of 2008-2009. All of these preceded large crashes in the market and there is nothing to say that something like this won’t happen again.
That is not to be a doomsayer but history shows that these things usually end with a thud when the market starts to turn. In each case a falling stock market sucked all these new innovations down with it when it started to fall and we saw the mania in reverse: people clamoring to get out and selling off assets at any price to be able to exit. Holders of these assets may fund that they become increasingly illiquid and difficult to sell in such an environment.
There is no one trigger that for sure will bring this on so no one knows when it will happen. Bubbles can exist for year before popping. A number of fund managers lost their shirts trying to short the hot stock market in the late 1990’s banking on it dropping due to overvaluation. In the current environment, the inflation surge and the reaction from the Fed may prompt a larger drop in the markets than would be expected from these policies. Investors are already making bets on a surprise 50bps interest rate move in August when the Fed meets at Jackson Hole Wyoming.
In addition, that “diversification” argument is looking less compelling as the correlation between the Bitcoin price and the stock market has rapidly increased in the past year. From having almost none or negative correlation, Bitcoin now has the same correlation with the stock market as bonds but in the same direction at the stock market. This positive correlation means when the market drops, you can expect a drop in Bitcoin.
It’s going to be quite difficult to hedge a scenario like this completely but a mix of real estate, commodities and foreign shares can help offset both inflation and an adverse market reaction to higher rates. Time will tell whether late summer will be the tipping point or if the mania will continue on further.
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