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Crowd behaviour at highs and lows and what the 5% do instead when trading Crypto

CODE YELLOW

As 2018 draws to a close, cryptocurrencies have been routed. But while the prices have been getting hit hard, one behaviour pattern is constant.

Sentiment, in late 2018, is at the opposite end of the scale from the euphoria surrounding Bitcoin and cryptocurrencies a year ago. In December 2017, the only way was up, and valuations for Bitcoin was (on the cautious side) $25,000, and on the less cautious side, half a million plus.

Then, as the cold light of 2018 dawned, things began to change. Bitcoin has had three previous price bubbles, falling 93.76%, 75.41%, and 86.89%, and in mid-December 2018, Bitcoin is down 84.12% from its all-time high and is approaching its worst-ever losses from a previous high.

Sentiment is one of the things that can help put some perspective on the current cryptocurrency downtrend, and a useful phrase to remember, just before you hit the order button, is “When the only is up, the only way is down.” (And vice versa)

In December 2017, the only way was up for cryptocurrencies, and the opposite happened, and now, one year later, ask yourself is sentiment saying, “When the only is down…?”

If you study the history of speculative markets, from Tulip mania in the 1630s to Bitcoin in 2017, you’ll find one common denominator. FOMO.

Read on…


Fatal Flaw

The term “bubble” is used anytime an asset’s price is driven, by speculation, far away from its intrinsic value.

In the last twenty years, we’ve had an unprecedented number of bubbles. Tech stocks in 2000. Real estate in 2006, Debt in 2007, Bonds in 2013 and Bitcoin in 2017.

Maybe it’s a new technology or a more efficient service, perhaps it’s a scheme where, if successful, it could change your life, but whatever it is, and whatever it does, the behaviour is always the same.

Bubbles start, slowly at first, gathering momentum. Sometimes the underlying asset has been around for years, like property, and sometimes it’s something new like cryptocurrencies, but there’s usually a catalyst. It might be cheap money, created by lower interest rates, providing the fuel for the real estate bubble that caused the collateralisation of mortgage debt on an industrial scale. It might be the commercialisation of technology, the internet, whose use had been changed, from academic communication to mass market communication.

In the Smart Dust article, video, and podcast, we talked about the Hype Cycle. Gartner, a leading research consultancy company, track the emergence of new technologies with a hype cycle curve.

A hype cycle

A hype cycle

A hype cycle is a useful model to help track a new idea from its initial trigger, caused by a small number of enthusiasts until the idea becomes a widely used product or service that’s used by everyone.

Take the internet. In 1991, if you wanted an email address, you could subscribe to a commercial service, but you still had to write your own dial-up modem connection script. Then came CompuServe; then, the breakthrough idea, the web browser.

By 1995, users had driven prices of commercial companies using browser technology to very high valuations. You’ve heard of Yahoo, but what about Lycos? Some, at first, promising companies and business models fall by the wayside. Some go out of business, some get taken over, some are acquired by bigger companies for their patents and the underlying technology is used to produce something else, or block a competitor from producing it.

Lycos started out life as a research project at Carnegie Mellon University’s Pittsburg campus in 1994. Lycos Inc was formed in 1995, backed with $2 million of venture capital.

Lycos IPO’d and went public in 1996, and in 1997 became one of the first profitable online businesses. As the money rolled in, Lycos acquired other brands, building on its online presence. In 1999, Lycos was one of the most visited websites in the world. In May 2000, Terra Networks acquired Lycos and paid $12.5 billion for it.

A company, that, pre-google, was started with $2 million and was sold six years later for $12,500 million. A 624,900% increase.

Looking back from today, we now know that March 2000 was the top of the tech bubble. The Nasdaq would eventually drop 78.4% over the next three years.

Over the intervening years, Lycos never regained its place as a leading search engine, passed from pillar to post, Lycos was eventually sold for $36 million in 2010 — a drop of 99.712%.

Bubbles drive prices up to unrealistic expectations. Tech stocks in the mid-1990s were the hottest market in the world. Companies that were valued at a few cents, with no profit, and little in actual sales, put up a website and were worth, on paper at least, millions. People, all over the world, quit their jobs for the coolest new profession in town — day trading stocks — on the internet. It ended in disaster.

Nasdaq — the stock market for the 21st century.

Nasdaq — the stock market for the 21st century.

For a few years, it seemed that anyone with a small amount of capital could buy a tech stock and sell it later in the day for a profit. In early 2000 whole page adverts, appearing in the leading newspapers, and even on TV, proclaimed (in that, cool and deep, James Earl Jones voice), “Nasdaq — the stock market for the 21st century.” As the Nasdaq hit 5,000 for the first time in March 2000, financial pundits appeared on CNBC suggesting that the Nasdaq could overtake the Dow Jones Industrials, not only in price but as the Dow Jones replacement indicator of stock market performance.

Then it ended. A few made millions, but most lost it all.

It’s easy to think that bubbles are a new phenomenon, but they’re not. Legend has it that JP Morgan Jr., the son of the legendary American banking titan, took a taxi ride downtown to his offices one morning. During the journey, the driver mentioned he was not going to be driving the taxi for much longer as he was investing his income in stocks. Morgan thanked the driver, walked into his office, picked up the phone and started selling his stock holdings. The date: 15th of October 1929.

On October 24th, 1929, the Wall Street crash began.

The JP Morgan story is almost certainly a work of fiction, but when the majority of investors have placed a one-way bet, and the investment idea is so well known it has trickled down into all corners of mainstream society; then, ask yourself, who is left to take the other side of the position?

You may be of the view 1929 is ancient history, and today, with our sophisticated economic models, crashes like 1929, a crash that caused a global depression, can’t and won’t be allowed to happen again. Generation after generation thinks like that.

The financial crash of 2008 was caused by metamorphosing mortgage debt into securities. Securities were given triple-A ratings by the credit rating agencies and invested in by everyone from local governments to investment funds.

The mantra is always the same. It’s different this time.


Alchemy

So, in 2008, how did the establishment do it? How were we pulled back from the brink of financial collapse?

A country’s output is measured by its Gross Domestic Product, or GDP. It’s the value of everything a country produces inside its borders.

GDP is calculated using the formula Y = C + I + G + X.

C = Consumer spending

I = Business investment

G = Government spending

X = Net Exports (imports - exports)

In 2017, consumer spending made up 68% of US GDP, so if consumers stop spending, then that becomes a huge problem.

Why?

Because an economy is made up of transactions. Realise that one person’s spending is another person’s income. Today, thanks to central banking, we live in a world where the fiat money we spend on goods and services is not based on anything but trust. Debt has been created on an unprecedented scale, to pull the global economy back from the edge.

They called it Quantitative easing. The world’s central banks injected money into the system by buying securities (bonds) from its member banks. This has the effect of increasing the amount of money in the system. Governments also issue debt (bonds), and the central bank buys them. This helps keep interest rates low because the central bank absorbs any excess supply in bonds. This leads to artificial demand overwhelming supply in the bond market, and this, in turn, drives bond prices higher. As the price of bonds increases, the interest rate received for holding the bonds goes down. QE became so extreme during 2017 that nineteen countries had negative interest rates on their two-year bonds, including Switzerland and Germany.

The central bank buys the securities (debt) with credit. But where does the money come from? Where does a central bank get the credit to purchase the debt?

This is where the magic happens. A central bank can create credit out of nothing — out of thin air. This ability to create credit is also known as money printing.

Most people don’t realise when they save money in a bank, all they are doing is forgoing their consumption of goods and services, and instead, allow the bank to lend their money to someone else, so the other party can purchase the goods or services themselves.

It’s ten years since the financial crash. The US stock market is up 341% from its 2009 low to the September 2018 high, but look a little closer, and things might not be as healthy as they seem.

The amount of debt created as a percentage of GDP has increased from 282% to 318% since 2008, a rise of just under 13%, but to put some perspective on this number, the amount of debt created globally has risen from $84 trillion in 2000 to $250 trillion in 2018, up 197.6%.

Where has all this cheap money gone? A lot of it flowed into the stock market. The media reports, financial institutions, like banks, have increased the strength of their balance sheets by holding less debt compared to assets, increasing their liquidity ratios.

But what about the other stock market sectors?

Companies borrowed heavily and bought back their shares. This has the effect of increasing earnings per share because there are fewer shares in issue. The investment industry uses the earnings per share multiple to compare stocks in the same industry and to give investors advice on how much they are paying for the future returns of the company.

But the earnings multiple does something else too. When a stock gets an earnings re-rating, the stock price will generally increase in-line with the increase in earnings percentage, but this increase will cause the stock to be valued at a higher multiple, and this applies a multiplier effect to the share price.

It works like this.

A company priced at ten times earnings announces a 25% increase in its profits. The share price should increase by around 25% because of this news. But a company that is currently priced at ten times earnings has shown it’s possible for it to generate returns of 25%. For a company growing earnings at 25%, a rating of ten times earnings is too cheap compared to the growth rate so the investment industry will re-rate the future earnings of the company upwards.

If the investment analysts re-rate the company from 10 times to 20 times future earnings the following multiplier effect will greatly increase the share price.

Let’s say the price of the company before the earnings increase announcement is $100.

$100 (share price) + 25% (growth) x 20/10 (new multiple / current multiple) = 100 + 25 x 20/10 = $250 — minus the $100 dollar starting price = 150% gain.

That’s a $25 or 25% gain from the increase in earnings growth and a $125 or 125% from the future earnings re-rating.

This is how the stock market works.

QE pushed the prices of bonds up, and the returns from bonds down. The extended period of artificially low interest rates, because of near zero, and in some cases negative interest rates on government-issued debt, made it attractive for companies to raise debt to buy back their shares, boosting their profits, which in turn has caused the stock market to soar, not only through artificially enhanced earnings but because of the removal of other attractive alternatives, like bonds.

The US stock market is up over 300% in 10 years. But it might not be as healthy as you think. Now you know why.

The cost? More debt.


History Repeats — and Rhymes (sometimes)

The first bubble of the modern age was Tulipmania.

Tulipmania

Tulipmania

It was called the “Viceroy.” In 1637, the Viceroy tulip bulb was offered for sale at a price equivalent to what it took a skilled worker fourteen years to earn.

If you use 2018 household median income in the United States as an average income, then, the Viceroy cost $868,000 at the tulip mania bubble high.

Between 1636 and February 1637, prices rose from around one month’s income for a skilled worker to fourteen years income.

On February 3rd, 1637, the bubble burst, and by May 1637 tulip bulb prices had collapsed over 90%.

Few people can relate to something that happened 381 years ago, but again, if you look a little deeper, market regulation and socioeconomic behaviour would have been very familiar.

For example, the Dutch had a formal futures market based on tulip bulb contracts. And short selling, (that’s selling something you don’t own to open a transaction in the hope you can close the transaction by buying underneath your sell price) was banned.

Sound familiar?

In the South Sea bubble of 1720, Sir Isaac Newton, the father of modern science, was an early investor and cashed out with a profit of £20,000. An absolutely enormous sum in those days.

South Sea Company

South Sea Company

Newton affected and unable to switch off his caveman’s brain, saw the South Sea stock go ever higher without him. His fear of loss kicked in, and he bet it all, hoping for even higher prices.

A few short months later Newton lost the lot… and more.

Tomorrow morning, when you look in the mirror, ask yourself, are you brighter than Sir Isaac?

Until we evolve into a better version of ourselves, human behaviour is a constant.

2019

There’s no doubt 2018 has been a difficult year for cryptocurrencies, but, if you take the time to look under the surface, the Bitcoin network is not quite being given its last rites. (See Vital Signs)

Forecasting the future

Forecasting the future

Forecasting the future is game played by the 95%. The 5%, the most consistent and profitable group of investors and speculators, prefer instead to listen to the market. The 5%, monitor supply and demand, looking for moments in time when the likelihood of a price movement in one direction, either up or down, shifts in their favour.

Maybe you think cryptocurrencies are just a fad. Perhaps you agree with some of the establishment's market commentators that Bitcoin has no real value, and it will disappear from history; too slow to be a real-time fiat currency replacement and too flawed through a lack of supply and demand balancing to be a store of value. One senior commentator even quoted from Shakespeare — “I come to bury Bitcoin, not to praise it.”

The Shakespeare quoting economist might be right, and Bitcoin might go to zero and completely fail, but being fair to his argument, even he stated that the underlying technology behind Bitcoin might have some economic value.

Every year, Warren Buffett, the world’s most successful investor and speculator, writes an essay to his shareholders. In 1987, Buffett wrote about Mr. Market, a metaphor taught to Buffett by his mentor Benjamin Graham, to explain the psychology of speculative markets.

Mr. Market swings between feeling euphoric and depressed. He shows up every day and offers you a price. When he thinks you can only see the upside of a business, he offers you a high price, because he doesn’t want you to benefit from future profits that otherwise could have been his — if he didn’t sell to you. Sometimes though, he thinks you only see the negative side of a business, so he offers you a low price so he won’t have to pay you much if you offload your inventory on him.

Buffett goes on to explain that even though Mr. Market shows up every day, you don’t have to do anything, and you can ignore him. Ignore him or not, Mr. Market will be back tomorrow to offer you a new price.

Buffett is famous for using his deliberately home-spun stories when offering his advice.

What Buffett is saying is that you should pay attention to when Mr. Market shows up in a depressed state of mind and offers you a price much lower than what the asset is really worth. Vice versa, when you’re offered a price far in excess of what the asset is worth.

Buffett’s message comes with a warning too. Mr. Market should be used as a servant, not as your master.

One of the techniques Buffett uses is value investing. Using his Mr. Market metaphor, If, one day, Mr. Market offers a price much lower than the price you estimate the business is worth; then, you should take advantage of Mr. Market’s mood.

How do you put a value on a cryptocurrency?

One technique, used by the 5%, is to take a step back and look at the market from 50,000 feet.

First, the 5% ask what problem the cryptocurrency solves? And second, they ask is it scalable?

You might not believe in Bitcoin, but that’s not the point. By asking what problem a cryptocurrency solves, the 5% can estimate the issues and roadblocks that will have to be overcome before the technology reaches stage five of the Gartner hype cycle.

Facial Recognition Technology

Facial Recognition Technology

This week in the UK, it was announced that the Metropolitan Police are going to trial live facial recognition technology in Westminster, London.

Earlier this year, facial recognition software was used to monitor a Taylor Swift concert in an attempt to cross-reference the audience with a database of known stalkers.

In an earlier article, “Games Without Frontiers,” we discussed the trilemma. Think of a trilemma as a thought experiment. Place three choices on the points of a triangle. At any one time (epoch) you can have two of the three choices, but never all three.

We used the international relations trilemma from the World Economic Forum website.

Economic Context

Economic Context

Capital Movement : Democracy : International Order

Then we discussed, using evidence from recent history, the rise of international order, and the persistence of capital movement since capital movements are the arteries of global finance. This suggests democratic values will decline in the near future. Real-time evidence suggests this is taking place, as more countries adopt populist views and begin to isolate themselves, leading to trade wars with tariffs on trade.

In this environment of less trust, the 5% compare the likelihood ratio of blockchains that solve the problem of protecting yourself from your home countries monetary policy, to the blockchains that could be used to store big data.

Centralised databases are targets for hackers and cyber-crime, and are potential points of weakness for a country’s homeland security. Data, once stored formally in ordered tables and queried using languages like SQL, are being replaced by de-centralised databases. Databases that store data in an unstructured format and can cope with the velocity of data generation. It’s not a great leap to take a language like Hadoop, to retrieve data stored in a de-centralised blockchain.

In the future, it’s likely that everything you do will be recorded. Not just the good stuff. Every exam you fail, every mistake you make, even genetic weakness will be stored in the permanent ink of a blockchain.

Another possible downside is that blockchains, seen by the early adopters of the technology as a way to free themselves from the control of the establishment, could, in the end, be used as the ultimate mechanism of control.

History is full of irony.

For example the 5% might ask — What is more likely to happen in an environment of less trust: Governments will allow their citizens complete control of their money, giving them the autonomy to send money across borders, protecting them from macroeconomic control via monetary policy, or governments will use the technology behind early generation cryptocurrencies as a trusted and secure data storage system?

As Bitcoin and the top alt-coins hit new lows for 2018, losing over 80% of their value, with some losing over 90%, the 5%, don’t issue a code yellow. Instead, they take a step back and look at the big picture.

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