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Bitcoin is the Poster child Of an Unhinged Financial System

By David Scott | Monday 4 December 2017


 


Investors are ignoring warning signs that financial markets could be overheating and consumer debts are rising to unsustainable levels, the global body for central banks has warned in its quarterly financial health check. The Bank for International Settlements said over the weekend that the situation in the global economy was similar to the pre-2008 crash era when investors, seeking high returns, borrowed heavily to invest in risky assets, despite moves by central banks to tighten access to credit.

The BIS, known as the central bankers’ bank, said attempts by the US Federal Reserve and the Bank of England to choke off risky behaviour by raising interest rates had failed so far and unstable financial bubbles were continuing to grow. Claudio Borio, the head of the BIS, said central banks might need to reconsider changing the way they communicated base interest rate rises or the speed at which they were increasing rates to jolt investors into recognising the need to calm asset markets. “The vulnerabilities that have built around the globe during the long period of unusually low interest rates have not gone away. High debt levels, in both domestic and foreign currency, are still there. And so are frothy valuations. What’s more, the longer the risk-taking continues, the higher the underlying balance sheet exposures may become. Short-run calm comes at the expense of possible long-run turbulence,” he said.

The BIS said the benign global economy, which is predicted by the International Monetary Fund to see growth accelerate next year to 3.7% from 3.6% this year, was encouraging investors to dismiss concerns about high debt levels and growing asset bubbles. Economists have become concerned that high-risk investments such as European junk bonds yield similar returns to relatively safe investments such as US government bonds. There are also concerns that some of the most popular investment vehicles such as exchange-traded funds are backed with vast sums of borrowed money. The BIS was one of the few organisations to warn during 2006 and 2007 about the unstable levels of bank lending on risky assets such as the US subprime mortgages that eventually led to the Lehman Brothers crash and the financial crisis. The organisation’s chief economist at the time, William White, who now chairs the OECD’s review committee, warned last year that global debt levels had escalated to unstable levels largely in response to almost zero interest rates to create a situation that was “worse than 2007”.


Surreal moments are a hallmark of any bubble. So when pop star Katy Perry went on Instagram last week to say she had met the world’s most famous investor, Warren Buffett, and asked him what he thought of cryptocurrencies, for me alarms clanged and red lights flashed. It is important to remember that Buffett declared three years ago that Bitcoin, then valued at around $600, is a ‘mirage’ and a ‘joke’. If bitcoin is indeed a cryptocurrency bubble, it's already much larger than the NASDAQ in the late 1990s, the Dow in the roaring 1920s, and silver in the late 1970s. Birinyi Associates has studied bitcoin versus the 10 largest financial bubbles and Bitcoin has shown particular bubble-like qualities particularly in the past week, surging past $11,000 before trading back at about $9,600 on Thursday afternoon. It started November at about $6,500. Of the 10 events Birinyi studied, bitcoin was third largest, behind an 18th-century French financing scheme around the development of the Mississippi Valley, known as the Mississippi bubble, and the one-day 31 percent surge in Qualcomm in December, 1999. According to Birinyi Associates, it was a Wall Street analysts call for a $1,000 target that set Qualcomm shares on fire.

The virtual-vertical price rise of bitcoin, the digital currency, has been likened to the NASDAQ bubble. But there’s really no comparison, says John Authers in the FT. Since bitcoin started trading in 2010, its inflation-adjusted annual average return has been 411%; its best yearly performance, 2013, saw a real return of 5,426%. This is “nothing like what can be expected from a stock market”. The best real annual performance by a stock market on record is Norway’s 167% jump in 1979. As far as valuation goes, adds Stephen Gandel on Bloomberg Gadfly, consider that at the height of the dotcom insanity, the NASDAQ index had a trailing price-earnings ratio of 175. Bitcoin’s earnings are the transaction fees it generates. Divide the total of these in the past year into the market cap, and you get a trailing P/E of more than 710. As with all bubbles, “the underlying technological revolution is real”, as The Wall Street Journal’s Aaron Black points out. Bitcoins are based on blockchain, which could “change how commerce is conducted by cutting out the middleman”.

Blockchain is a digital, encrypted cloud-based ledger that records all transactions across a chain of computers – an Excel spreadsheet that can only be modified with the agreement of others, essentially. As all transactions are recorded and transparent, there is no need for an intermediate entity to verify them and deal on others’ behalf. People could trade stocks with each other. Beyond finance, people will be able to rent car-rides and houses to each other without the likes of Airbnb and Uber. But, bitcoin is hardly the only application of blockchain; there are more sophisticated versions. And there are certainly other digital (or “crypto”) currencies out there too, adds Gandel – more than 1,320, to be precise.

Bitcoin fans say they have scarcity on their side, because the company says it will only ever produce 21 million bitcoins. “But while the supply of bitcoins may be fixed, the supply of ways to invest in them (and other cryptocurrencies) is not.” Futures contracts are on the way, and exchange-traded funds are sure to follow. As more and more people access the investment, the rarity value will recede. This mirrors what happened in the dotcom bubble. People could only invest in the advent of the internet through a handful of dotcoms at first. As more and more joined the party, the illusion of scarcity dissipated and the bubble burst. Bitcoin might not end up replacing banks but it will force them to reduce their outrageous fees the same way that Skype and WhatsApp forced telcos to reduce the cost of SMS and voice calls. But For now, bitcoin is basically a stock that will only ever have 21 million shares and never pay a dividend.


Recent months have seen a steady and growing flow of institutional investors', and market analysts', and researchers' warnings about the medium-term sustainability of the financial assets prices. Both, the IMF and the Bank for International Settlements (BIS) have documented evidence on the buildup of systemic imbalances across the financial markets, from bonds to stocks to structured financial instruments. And the Claudio Borio-led research team at the BIS have shown time and again that systemic financial crises are increasing both in frequency and severity. No period is worse for bears than when it’s the best time to sell stocks. It’s the polar opposite of when conditions are worst for bulls, right when it’s the best time to buy as it was in January-March 2009. The exhaustion factor is enormous and it’s called capitulation.

November’s close marked the 13th consecutive month straight up for global markets. Nothing but up with fewer and ever smaller dips in between. Deutsche Bank’s Reid illustrated the point: “We’ve never had such a run with data going back over 90yrs”. Yet in my view we are sitting on a generational opportunity to lighten equities as it could be argued that conditions will never be better for bulls as the carrot of free money is coming to an end. In addition it could be argued that the prospect of US tax cuts is the final carrot that this extraordinary period of monetary experimental desperation has to offer. After the US tax cuts there are no more carrots to dangle in front of markets hence we’re finding ourselves in an environment of an imminent top, but the watershed moment will come when people want to sell. How will markets handle a situation when sellers of passive funds that have powered the market up over recent times suddenly appear and find no willing buyers to relieve them of there burden at such rarefied levels.

When markets were peaking back in September 2014, China's total credit growth from all sources including its $15 trillion shadow banking system had slowed to a 15% annual rate, but then its was gunned to upwards of 30% from early 2016 onwards as global markets wobbled and Xi Jinping feared it may put a halt to him being re-elected for a second term. But now that Xi's thoughts have been enshrined in the Communist Party constitution, along with the wisdom Mao, Chinese credit growth is plummeting. Even China's new Red Emperor recognizes that $40 trillion of debt on a suspect $12 trillion economy (its actually far lower when massive malinvestments are deleted from the reported GDP) is a recipe for collapse. Xi Jinping is in view delusional about the capacity of centralized bureaucrats to create powerful and sustainable economic growth by taming and stabilising the greatest Ponzi-style digging, constructing, borrowing, spending and speculation orchestrated in human history. But ultimately his goal is a third term in 2022, and in the interim this means he has to dampen down China's fevered borrowing and building spree with urgency. Markets are not prepared for this as the other bid Central Banks of the world start to shrink balance sheets with quickening vigour.

When an Investors’ only hope is selling it on to a greater fool, it is the very essence of a massive bubble. Peering into 2018, the bulls are likely to be slaughtered.

David Scott is an Investment Manager & Market Commentator at Andrews Gwynne


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