The Cryptocurrency Craze: Why Many Are Asking Is Cryptocurrency a Good Investment?
If the history of investing could be encapsulated in a textbook, an entire chapter could be dedicated to these last 16 months. Financial markets managed to squeeze decades of bizarre events into one year. These ranged from lockdown-driven stock-market turmoil to negative oil prices, “meme” stocks, NFTs (non-fungible-tokens), and zero-revenue special purpose acquisition companies (SPACs) with multi-million-dollar valuations. The headliner in this roster of head-spinning stories is the cryptocurrency craze.
As the popularity of cryptocurrency has surged, a closer look at the details is warranted. We always try to understand what drives any investment thesis. Along with that, we evaluate investments in the context of risk management and diversification. The ultimate goal is to filter out the noise and determine if it can improve the overall portfolio.
What is Cryptocurrency?
We can start with a very broad definition of cryptocurrency. Given the complexity, capturing the essence in a few sentences will almost certainly fall short. But we point to a definition from one of the most popular cryptocurrencies, Bitcoin, for some insight. According to their website (https://bitcoin.org/en/faq#what-is-bitcoin):
“Bitcoin is a consensus network that enables a new payment system and a completely digital money. It is the first decentralized peer-to-peer payment network that is powered by its users with no central authority or middlemen.”
At its core, cryptocurrency is intended to facilitate rapid and secure financial transactions using blockchain technology across a secured, decentralized network that avoids the use of fiat currencies issued by sovereign countries. The blockchain technology has great potential for various uses apart from cryptocurrency and is already being put to productive use in other ways.
Why So Much Hype?
Any potentially groundbreaking technology has futurists and visionaries espousing the potentially world-changing ramifications, which could shake the foundations of our global financial systems. This certainly sounds enticing, but what’s driving much of the recent interest is demonstrated in the chart below. The age-old prospect of another way to “get rich quick” (with minimal effort) has proven yet again to be tempting to many investors. There are certainly some long-term investors buying cryptocurrency, but many are buying with the hope that someday soon they can sell it to someone else at a higher price. This is not investing, but pure speculation.
If Bitcoin experienced the same returns as the S&P 500 over the last 16 months, would there be so many talking about it?
Why We are Cautious
A key aspect of the bull case is that cryptocurrency is everything a traditional fiat currency is not. It is designed to have a finite number of coins. This in theory means it is not subject to a government’s proclivity to “print” money, which can drive inflation and help with debt but reduces the currency’s purchasing power. It is no coincidence that prospects of inflation have driven investor interest in cryptocurrency as a potential hedge. But there are many reasons to remain cautious about cryptocurrency:
- Unreliable store of value: The key job of any currency is to be a consistent, reliable store of value. Anyone holding currency should have a general sense of what it will buy, at least for the foreseeable future. Given the volatility of these cryptocurrencies thus far, the store-of-value feature is clearly not yet functional.
- Extreme volatility: Cryptocurrency’s eye-popping returns have attracted many new investors. But those returns have come amid extreme volatility as shown in the nearby chart. Bitcoin has experienced much sharper drawdowns than the S&P 500 since early 2020. Speculators have added fuel to the fire by using leverage (borrowing to buy). A recent Wall Street Journal article pointed out that margin debt makes up about 2% of the $49 trillion U.S. stock market, but for the $1.6 trillion crypto market, it’s 6%, three times that amount.
- Lack of Security: Security is a major concern. Cryptocurrency markets are unregulated, digital wallet apps are anonymous, and services are neither regulated nor insured. If there is software failure, theft, or even lost passwords, investors have nowhere to turn for help. According to the Wall Street Journal, hackers stole $120 million of cryptocurrency in 2020 and another $411 million as of early June 2021. This seriously undermines the argument that it is a secure way to transact. Organized criminal groups like drug cartels have been increasingly using Bitcoin as a more efficient means to execute anonymous transactions. This expanding black market has grown more concerning over time.
- Sentiment Over Fundamentals: The most consistent long-term returns come from investments that can be priced based on fundamental value. This reduces the impact of investor sentiment on the price. Cryptocurrencies have traded with extreme volatility driven by rapidly shifting investor sentiment, most infamously as a result of overnight tweets from Elon Musk. It is a market where emotional reactions to a headline or tweet can lead to violent reversals.
- Government Regulation Headwinds: A country’s ability to manage its currency is a critical tool in a functional economy, for better or worse. It seems unlikely that the governments in the U.S., China, the European Union, and other large countries will stand by and watch their sovereignty erode with the global adoption of a replacement currency. China has already started to clamp down on cryptocurrency, leading to recent price declines, and other nations have indicated similar intentions.
The Barbershop Factor
The crypto-craze has several parallels with the dot-com bubble of 1999 – 2000, including several price charts. But even more striking is “The Barbershop Factor,” where even the barber (or neighbor, Uber driver, mechanic, college student, etc.) can be heard telling others how they are “killing it in crypto” and reaping life-changing profits. It could be different this time (the most dangerous words in investing). However, when it seems nearly everyone is talking unprompted about how they are doing with their crypto holdings it could be a sign of peaking investor sentiment and potential pain ahead.