Bitcoin — Keep Your Eyes on the Highs

bitcoin market skyrocketing

Bitcoin is all the rage at the moment. No wonder…it’s trading around US$4,800, up a gazillion percent or so over the past five years.

I’ve often wondered how the market comes up with such a valuation. There are many potential reasons, which I won’t go into here, but ultimately, no one really knows.

However, there is one interesting fact worth thinking about when it comes to bitcoin. That is, the ‘mining’ aspect.

Mining for bitcoin occurs via heavy computational power trying to solve mathematical problems. This process strengthens the blockchain technology that bitcoin operates on (it adds ‘trust’ and immutability to the system). The stronger the technology, the more ‘valuable’ Bitcoin becomes.

Given the rise in value of bitcoin, a new industry has evolved just to ‘mine’ the coins. The miners are rewarded with (increasingly scarce) bitcoins for solving mathematical problems, which in turn strengthens the blockchain.

But to solve the problems, you need massive computing power. You can’t do this at home, folks.

Which brings me to my interesting fact of the day. According to the recently released CSRIO report on blockchain technology, Data 61:

Bitcoin mining currently accounts for 0.05% of the world’s energy consumption, which could power over a million households in the United States of America. This is the hidden transactions cost of the system.

I don’t know about you, but I had no idea bitcoin mining was soaking up that much juice!

The pro-bitcoin argument is that all this computational power is going into building and strengthening a technology (blockchain) that will profoundly change the way our economic system operates in the future. And the price of bitcoin is a reflection of the strength of the technology.

That makes sense.

But is this a nice symbiotic relationship, or a confused chicken and egg thing?

That is, does the price of bitcoin respond to the work of the miners, which then motivates the miners to work harder to gain the rewards of the higher priced bitcoin?

Or are the miners only mining to get rewards in high priced bitcoin? If the price falls will the miners hang around? 

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I suspect it is more a case of the former. However, I doubt the current price of bitcoin accurately reflects the work of the miners. That is, I doubt that the price of bitcoin reflects its ‘intrinsic value’.

What is its intrinsic value? I don’t think anyone knows that either. At least with a stock or a bond, you can work out intrinsic value using an estimate of future cashflows and an appropriate ‘discount rate’ (interest rate).

But with bitcoin, how do you put a price on the strength of the underlying technology? That’s the market’s job. As it tries to estimate the correct value, it will overshoot and undershoot intrinsic value.

My guess is that it’s currently overshooting. But’s that’s just a guess. I really have no idea. In this situation, it’s best to consult a chart. Let’s have a look…

Bitcoin, US Dollar 10-10-17
Source: Optuma
[Click to open new window]

As you can see, the price of bitcoin has gone parabolic this year. It peaked at a closing high of US$4,874 on 1 September. Two weeks later it had plunged to an intra-day low below US$3,000.

But since then, bitcoin has bounced. It’s now challenging the 1 September high.

This will be a key test of short term performance. If bitcoin fails to make new highs, and instead sees renewed selling around here, I’d expect to see a decent correction unfold.

In parabolic markets, you often see extreme volatility near the top. But if the bounce fails to go on and make new highs, you should be wary. At least in the short term.

I’m sure Richard Thaler would have some thoughts on this. He’s the behavioural economist who just won a Nobel prize in economics. Behavioural economics brings human psychology into the economic decision making process. It recognises we are irrational, but not randomly irrational.

As this New York Times article points out (via the Financial Review)

Mainstream economics was built on the simplifying assumption that people behave rationally. Economists understood this was not literally true, but they argued that it was close enough.

Professor Thaler has played a central role in pushing economists away from that assumption. He did not simply argue that humans are irrational, which has always been obvious but is not particularly helpful. Rather, he showed that people depart from rationality in consistent ways, so that their behaviour can still be anticipated and modelled.

The chart of bitcoin, above, is a good representation of predictable irrationality. That is, strong price moves bring more and more people into the market. And the more people that come into the market, the further the price moves away from ‘intrinsic value’.

That’s what produces the ‘parabolic’ price curve.

Of course, I’m not suggesting everyone who buys bitcoin is irrational. Absent heavy-handed regulation, its design and structure virtually guarantees higher prices over the long term. That’s thanks to the scarcity of the coins on issue and the difficulty of mining them as this scarcity increases.

But in the short term, anything can happen. So keep your eye on the 1 September high. That’s an important level to watch.

Regards,

Greg Canavan,
Editor, Crisis & Opportunity

Greg Canavan

Greg Canavan

Greg Canavan is a Feature Editor at Money Morning and Head of Research at Port Phillip Publishing.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

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