Wall Street has been obsessed with bitcoin in 2017, with investors and experts as polarized as ever on whether bitcoin is the future of global currency or simply the latest financial market bubble.
Unfortunately for bitcoin bears, recognizing a potential market bubble in real time is only part of the equation. Timing (and profiting from) a bursting bubble can be much more difficult than it looks.
UBS is the latest firm to see all the tell-tale signs of a bubble in the bitcoin market. The price of bitcoin has skyrocketed more than 1,600 percent in 2017, and UBS says the lack of fundamental justification for the huge move makes bitcoin and other cryptocurrency markets “the bubble to end all bubbles.”
There are plenty of bitcoin bulls out there who would object to that argument, but even bitcoin bears may have a difficult time making money if the potential bubble bursts.
A look back at the dot-com tech stock bubble of the late 1990s reveals just how hard timing a bubble can be. The Standard & Poor’s 500 price-earnings ratio crossed above 30 for the first time in November 1998. At the time, the S&P 500 was trading at around 1,100. Even in 1998, there was a strong argument to be made that the stock market was in bubble territory, an argument that ultimately proved to be true. However, the S&P 500 index didn’t actually peak until roughly a year and a half later when the market hit 1,553 in March 2000.
In other words, investors that recognized the bubble in late 1998 were right. But over the next 16 months, stock prices gained more than 41 percent.
Bitcoin bears may see the current price of above $16,000 as a ridiculous valuation considering bitcoin was priced at around $775 one year ago. But many of the same bubble arguments could have been made about bitcoin at $775 as well. After all, bitcoin was priced at $12 as of December 2012.
There’s a famous investing quote often attributed to economist John Maynard Keynes: “The market can stay irrational longer than you can stay solvent.”
According to Brad McMillan, chief investment officer for Commonwealth Financial Network, short-sellers and market bears should always remember the Keynes quote before betting money on a bursting bubble. “You may end up being right,” McMillan says. “But if you are too early – early is wrong.”
David Blake, director of the pensions institute at the Cass Business School in London, says even the way market bubbles form and burst adds an element of difficulty to the equation.
“Timing precisely the top of a speculative bubble is impossible,” Blake says. Bubbles tend to inflate slowly over an extended period of time and then trigger an extremely volatile short-term sell-off.
“The liquidity that was there in the up phase completely dries up in the down phase,” Blake says. “This means that bears who are still there when the bubble bursts will be unable to close their short positions and can lose as much if not more than the bulls who did not get out in time.”
Mike Loewengart, vice president of investment strategy for E-Trade, says taking the short side of a market bubble is not for the faint of heart. It can also be very expensive. “The cost of going against the grain can add up – either the opportunity cost of sitting idle as the market pushes boundaries, or the unlimited downside of putting on a short that just doesn’t stick,” he says.
Long positions in stocks have unlimited upside, while potential risk is capped at 100 percent. However, the risk-reward potential is flipped for short bets, and traders can endure losses that are multiple times the size of their initial positions.
Bears can limit losses using put options instead of short-selling. But like the recently-launched bitcoin futures contracts, options have expiration dates, meaning bearish traders will need to time the crash properly to profit. Bears can improve their odds by buying put options with expiration dates further into the future, but these options will suffer from time value decay every day the bubble does not burst.
Despite how difficult it may be to profit off of market bubbles, there’s real value in recognizing them.
“Protecting against – not capitalizing on – a potential bubble can be a safer play for long-term investors worried about an imminent pop,” Loewengart says.
One of the best ways to protect against bubbles in individual asset classes is to maintain a well-diversified portfolio of stocks, bonds, commodities, real estate, cash and other assets. Patience is…
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