In recent years, Bitcoin has experienced extreme market volatility, which has led to significant price increases, followed by large losses in value. This is why many analysts defined bitcoin as an “overvalued” asset, whose “fundamental value” is lower than market price. This situation can evolve into something that in finance is called a “bubble”. i.e, a sudden price burst followed by a long bear market
How do we determine whether Bitcoin is a bubble or not?
First of all, we can define more precisely the concept of “bubble” in two ways: One, more intuitive, is “a price increase difficult to sustain”. In this case, the bubble is represented by a price explosion: the market becomes overvalued, so the value of the asset rises and then falls rapidly. The second definition is “a durable detachment from its fundamental value”. This means that the value at which the asset is traded on the financial markets differs from its intrinsic value and is therefore overvalued. There are even other definitions, however, starting from these two, we can determine two fixed points: a bubble implies that the price of Bitcoin is overvalued and, consequently, that it is destined to fall significantly. From a time perspective, except for a brief interlude of a few months, after the collapse of January-February 2018, the price of Bitcoin maintained almost always above $6000. This is a very valuable indicator, as it seems that the price has found some stability and that it’s sustainable over time (at the moment).
Yet this does not give us a complete picture of the situation: what could happen in the future? To better understand price sustainability, we need to look at the fundamental value of Bitcoin.
What is the fundamental value of Bitcoin?
Bitcoin was born as a currency, but, to date, it’s not much used as it: the price volatility is too high to be used as a payment method: contracting a debt or lending in Bitcoin is equivalent to going long or short on its price. That’s too risky. Consequently, the current value of Bitcoin as a currency is very low. No doubt there are expectations about the use of Bitcoin as a currency in the future, but today these expectations don’t reflect the current status of Bitcoin: if even projects like Lightnin’ Network were successful and allowed Bitcoin to scale its userbase, the problem of volatility would remain.
Some might argue that the fundamental value of Bitcoin isn’t its value as a currency and that it’s a purely speculative asset, whose sustainability is guaranteed by market consensus. In other words, Bitcoin could have no intrinsic value, but the market’s confidence in further price increases makes it sustainable over time. Assuming that this is right one of the definitions of “bubble” we’ve previously given, there can’t be “purely speculative assets”: any asset subject to speculation has a certain intrinsic value, even if sometimes it’s far lower than its market value.
There’s another possibility: BTC can be a store of value, a sort of digital gold. People may use it to diversify their wallets, saving them from inflation and instability in the traditional markets. However, stability is a key feature of a store of value, an Bitcoin is instead one of the most volatile assets in the world: a store of value is supposed to be stable and reliable, and not have a roller coaster-like pattern. So, it’s evident that looking at the fundamental value does not allow us to understand if Bitcoin is overvalued/a bubble or not. To answer this, we should change our point of view and adopt a psychological approach.
Market psychology and bubbles
Speaking of hardly sustainable price, the first thing we must look at is the investors. What kind of investors populate the Bitcoin market? Are they informed traders or inexperienced people who get caught in the moment? (find more HERE about market psychology) This question is crucial because bubbles are characterized by specific behavioral patterns: mass enthusiasm, obsessive attention to price, and flock effect. All elements that make prices rise to unsustainable levels and subsequently lead to a collapse. Indeed, if we carried out this analysis in December 2017-January 2018, there would have been very few doubts: the market was flooded with a wave of new inexperienced investors, the price moved according to rumors, and it was expected, in a few months, a lightning-fast adoption of Bitcoin worldwide. Bitcoin futures were creating an open door for institutional investors. A bitcoin bubble was growing. It was clear that the expectations were unsustainable, and in fact, that enthusiasm was followed by the collapse.
Today the situation seems very different from then: enthusiasm is lower, the price is expected to rise but in the long term, and the flow of new investors is much smaller. It seems, in short, that the market has found its normality. This “normality”, of course, is a relative concept: we’re talking about a non-transparent market, where most of the traded volumes are doubtful [link to bitwise study] and alongside many valid projects there are many others completely worthless. But we’re certainly not facing the “mass madness” that preceded the bitcoin bubble collapse of early 2018.
Google trends and financial bubbles
One way to better understand the situation is to look at Google trends: they tell us how often a certain keyword is searched for on Google. For example, if Bitcoin is in a bubble, then the word “Bitcoin” will be much searched for. It’s a pattern very often observed in traditional markets: the most searched companies on Google are those for which there’s more enthusiasm and therefore are the riskiest. They’re those in which many new investors can make the price rise in an unsustainable way, creating the premises for subsequent market collapses.
If we run this analysis for the word “Bitcoin”, we see that after the enthusiasm of a few years ago, the situation has stabilized. No new waves of enthusiasm, at least for the moment, as we can see from the graph below. We saw the incredible explosion of interest at the end of 2017 and since then a relative calm. This is good news for market sustainability, as you can see in the plot below.
Some final considerations
In conclusion, it’s evident that Bitcoin is somehow overvalued since its fundamental value is not clear: it was born as currency, but to date, it is not a valid payment method. In the same way, however, we no longer see the “explosive enthusiasm” of three years ago, which makes the situation appear less risky. There are two lessons we can learn from this analysis: 1) Be careful! When we talk about price and bubbles in Bitcoin market, we are talking about something difficult to evaluate. The academic debate about what Bitcoin is is dense, and we can’t take for granted that we know the answer. By not knowing what bitcoin is, it’s also difficult to understand how much it’s really worth, so you have to be careful. 2) The market is not an abstract entity: it’s made up of investors. Their behavior can tell us a lot about its future. For this reason, we’re careful when we see excessive enthusiasm in the market: usually, in finance, an exaggerated optimism is the premise for catastrophe.
All that said, we hope you enjoyed the article. Do you agree? How would you assess the intrinsic value of Bitcoin? Do you expect a bitcoin bubble? Let us know in the comments!