Ed Peters
October 27, 2021

In February, we published a stock market bubble checklist. Number 4 on the list dealt with mini-bubbles, and we mentioned cryptocurrency as an example of such a mini-bubble. Since February, this bubble has expanded, and there is now a chance it could encompass the broader market, as well. Extreme volatility and high transaction costs have limited the usefulness of cryptocurrencies as mediums of exchange. Meanwhile, speculation has increased, leading to the recent launch of bitcoin futures and ETFs. In addition, more and more investors seem to accept cryptos as a legitimate asset class, even a number of institutional-class investors. This could be dangerous if these theories are, in fact, rationalizations caused by FOMO (“fear of missing out”) rather than sound investment judgment. This shift would fulfill item number 3 on the stock market bubble check list, a “this time things are different” mentality. Here’s why.

Bitcoin and other cryptocurrencies have only been trading for a short while. So there is no empirical analysis that could convincingly study cryptocurrencies within a market or business cycle. Despite this lack of data, crypto is now being touted as a better inflation hedge than gold. The reasoning suggests that as limited assets, cryptos should hold their value better than fiat currencies and other traditional assets under inflation.

While this theory may be true, the long-term relationship between cryptocurrency and inflation has not been established. But increasing acceptance of this theory without evidence may be taking us to Number 3 on the stock market bubble checklist, an innovation that leads people to believe that the future will not be like the past. Since everything has changed, people treat past evidence as unreliable or undesirable, and focus only on the story of what lies ahead. No proof is needed. Such stories have an element of truth but are often extrapolated to unreasonable heights, resulting in unsustainable market conditions. The Tech Bubble of the late 1990s is one example. Perhaps we are seeing a similar story play out now with cryptocurrencies.

The “crypto as an inflation hedge” idea sounds like the kind of irrational rationalization that appears just as bubbles are about to pop. Speculators are trying their best to find a fundamental reason to justify trading cryptos. If FOMO is the real reason, the ending likely won’t be pretty. Let’s hope the broader market doesn’t get sucked in if that’s the case. Meanwhile, we can check off one more box leading to that stock market bubble. Only the “moral hazard” box remains.

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