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Bitcoin: Spotting a Potential Bubble

 3 min read / 

Since the start of the year, cryptocurrency valuations have soared. Bitcoin hit highs of $5,000 in September up from around $900 in January. Ethereum, the second largest cryptocurrency by market share, surpassed $400 at one point after starting the year at just $8. With accelerated growth and the lure of profits to be made is the hype surrounding cryptocurrencies to be believed? One word is lingering on potential investor’s minds: bubble.

Tulip Bulbs

Last month Jamie Dimon, CEO of J.P. Morgan Chase & Co, publically denounced bitcoin as “a fraud”. He added “it’s worse than tulip bulbs and won’t end well” referring to the age-old Dutch flower bubble of the 1630s. With cryptocurrencies fairly new on the scene (bitcoin was conceived in 2009) and not yet properly understood a market bubble would not be an unlikely event given the hype that surrounds them.

Yet the recent price hike of bitcoin and other cryptocurrencies does not necessarily mean they are in a bubble. One idea put forward by analyst and author Christopher Burniske is to look at the NVT Ratio (Network Value to Transactions Ratio). Working in a similar way to PE ratios, it looks at money flowing through the network as a substitute for company earnings. This is validated by the graph below, showing that the value transmitted via the bitcoin blockchain is closely tied to its network valuation.

Source: Woobull.com

 

From this, the NVT Ratio can be determined- although it cannot detect bubbles, it can distinguish between a crash or consolidation. If the NVT wanders outside of a normal range then this indicates the potential for a bubble.

Souce: Woobull.com

 

The above graph shows the NVT Ratio moving outside of the normal range twice in the past, once in 2011 and again in 2014. In both instances, these were noted as potential bubbles according to NVT ratio analysis and were followed by lengthy corrections in price.

To Buy, or Not to Buy?

Despite the somewhat pessimistic outlook on bitcoin’s future, many are still insisting it’s a buy. One of these is crypto fund manager, Mike Novogratz, who recently told Bloomberg: “this is going to be the largest bubble of our lifetime. Prices are going to get way ahead of where they should be. You can make a whole lot of money on the way up, and we plan on it”. Novogratz means business; he’s in the process of launching a $500m hedge fund, the Galaxy Digital Assets Fund, which invests in cryptocurrencies. Although still in the very early stages, Goldman Sachs has become the latest name to confirm an interest in trading bitcoin and other cryptocurrencies.

With more investors joining the hype, countries have begun studying cryptocurrencies and exploring ways to regulate them. Just last month the Chinese government banned initial coin offerings (ICOs) and outlawed coin exchanges. Speculation is also rife that The U.S. Securities and Exchange Commission (SEC) intends to regulate cryptocurrencies as securities. If regulations are introduced more widely this could have an impact on the market and thus the value of cryptocurrencies.

Conclusion

The surge of bitcoin has undoubtedly been unprecedented. Make no mistake that even if it fails to be adopted as a global currency its impact on financial technology will be huge. Have investors and traders shown excessive optimism in bitcoin and other cryptocurrencies? We won’t know for sure until the bubble has burst.

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