Bitcoin is not a bubble
By Scott Sumner
Over the past few years, I’ve noticed that people tend to predict that Bitcoin is a bubble, and then later suggest that a subsequent price drop shows that it was a bubble. Thus lots of pundits said Bitcoin was a bubble when its price was at $30. Then when it was at $300, even more suggested that it was a bubble. Each time the price plunges they say “I told you so.” Now the price of Bitcoin is over $3300, and even more people are saying it was a bubble. Noah Smith has a new piece in Bloomberg:
Yep, Bitcoin Was a Bubble. And It Popped.
His main piece of evidence is that the price rose sharply and then fell sharply. But that sort of price pattern also occurs in 100% efficient markets that are highly volatile because the fundamental value of the asset is hard to ascertain. And if there ever was an asset with a value that is difficult to ascertain, it’s Bitcoin. I have no clue as to what Bitcoin should be worth, and I doubt anyone else does either.
Bubble theories are only true if they are useful, and they are not useful. The people who said it was a bubble at $30 were implicitly giving you advice not to buy. Ditto for those who said it was a bubble at $300. This advice was exceedingly non-useful; in fact if you followed the advice of bubble proponents you missed out on the opportunity to earn a massive profit investing in Bitcoin. That’s why I don’t follow the advice of bubble theorists; it’s not useful. BTW, I don’t own Bitcoin for unrelated reason; I prefer index stock (or bond) funds.
In any efficient asset market with an extremely volatile price, the current value of the asset will usually be far below the historical maximum price. That’s equally true if bubbles don’t exist. BTW, I define a bubble as a price that is clearly too high relative to fundamentals, and thus an asset with a poor expected return, based on rational analysis. In fairness, Noah Smith defines it differently:
Formally, an asset bubble is just a rapid rise and abrupt crash in prices.
In the real world, the vast majority of times where people speak of bubbles they are using my definition, assuming market irrationality. And it’s clear that while Smith’s definition of bubbles does not explicitly endorse market irrationality, he thinks they provide pretty strong evidence for that hypothesis:
Defenders of the efficient-market theory argue that these price movements are based on changes in investor’s beliefs about an asset’s true value. But it’s hard to identify a reason why any rational investor would have so abruptly revised her assessment of the long-term earnings power of companies in 1929, or the long-term viability of dot-com startups in 2000, or the long-term value of housing in 2007.
Actually there is very good reason why investors might have revised their expectations for future earnings in late 1929, we were entering the Great Depression. But his point is valid for the 1987 stock crash.
Speaking of efficient markets, there’s another nail in the coffin of anti-EMH theories. When I started blogging in early 2009, people pointed me to all sorts “anomalies”, which they believed show that markets are not efficient. I’ve done many posts explaining how those theories have failed to do well in the period since I became aware of them. Recently I learned of the failure of another anti-EMH theory that was provided to me back in early 2009—value stocks as a good investment:
Just to be clear, I understand that value stocks had an amazing run for quite a long while. So did Bitcoin. My point is that anti-EMH theories are not useful, because by the time you start trying to take advantage of them they are likely to stop working. If that were not true then mutual funds based on highly robust anti-EMH theories would outperform index funds.
Market’s are amazingly efficient, and you’d be wise to base your life decisions on that assumption. For instance, if someone insists that his investment fund consistently offers really high returns, year after year, and the returns seem uncorrelated with the broader market, that should raise a red flag. Otherwise you might find that the investment manager made off with your money.
In contrast, the SEC does not believe in the EMH, and ignored warnings about a fund with implausible returns, year after year.