What can Bitcoin tell us about efficient markets, episodes, and the role of valuation?

One should probably be wary of writing yet another article on Bitcoin. If the number of press articles and blog posts was an indicator of bubbles, then there would be little debate. Aside from the fact that it is now the middle of winter, Bitcoin would certainly satisfy all the conditions to meet Aled Smith’s BBQ effect.

Nevertheless the Bitcoin phenomenon of 2017 does raise some issues with regards to the nature of asset pricing, which are probably worth commenting on.

Should Bitcoin form part of the ‘market portfolio?’

It is becoming harder and harder to dismiss Bitcoin as a niche market. The amount of energy spent mining Bitcoin on an annual basis is estimated to be greater now than that consumed each year by Nigeria, a country with over half the population of the United States.

In October the total market capitalisation of Bitcoins in circulation was reported to have become larger than that of some of the world’s most well-known companies, including Netflix, General Electric, and McDonalds.

Does this suggest that diversified investors ‘should’ hold some bitcoin as part of a global portfolio? If we were believers in efficient markets theory (we aren’t), then arguably the answer is yes.

Efficient markets theories argue that the optimal investment would be in the market portfolio (and cash, in proportion to how much risk we were willing to take). In the late 1970s, Richard Roll suggested that for this theory to be tested, this market portfolio should include every asset on the planet (and highlighted that this would be very difficult to do in practice).

Some have questioned Roll’s conclusions, but the argument highlights the blurred distinction between different types of assets. Broadly, ‘assets’ refer to anything that can be converted into cash, and can include commodities, stamp collections, beanie babies, and bitcoin.

‘Investments’ are a type of assets, which may pay an income over time, or which we expect to dispose of at some point in the future (ideally at a profit). This is partially subjective: one person may hold a painting to decorate their house but have no consideration of its future value, but if it turns out to be a long-lost Picasso, it will be an investment whether that was the intention or not.

Investment and valuation

It is very hard to know ahead of time whether some types of assets will ultimately make good investments. The original Bitcoin manifesto makes no mention of Bitcoin as an investment, or as a protection against devaluation of traditional currencies by central banks, but simply sets out a payment system that is not reliant on third parties. Similarly, any argument that the asset should be held as a store of real value due to its limited supply doesn’t seem to hold water. Here are the moves in the currency over the last three days for example:

Bitcoin has clearly become an investment for many, but charts like the above illustrate how it represents a purely speculative asset in many respects.

We don’t believe that investors should hold the market portfolio at all time. Instead we view valuation as an important component for knowing which assets will make good investments. As Eric mentioned recently there have been attempts to value Bitcoin, but there is very little sign that there is any valuation ‘anchor’ which would allow one to make an assessment of long term expected returns.

Episodes and valuation anchors

Many would rightly say that all financial assets are highly speculative in nature. The fiercest critics would argue that there is little to distinguish current US stock market behaviour from that of Bitcoin except degree.

This would be unfair. There are theoretical and empirical arguments for why valuation is significant for traditional asset classes. If people view the US market as overvalued, they can only say this because of some sense of what ‘fair’ value is. We define an ‘episode’ as a period in which behavioural influences, such as panic or euphoria, drive prices away from fair value. However, we acknowledge that assessing fair value is not straightforward. Pricing Model Uncertainty describes the theory that it is easier to assess fair value in some assets than others, for example, bonds with their regular cash flows have a stronger anchor than mainstream currencies. As a result there is far more evidence of overshooting‘, and extreme departures from fair value, in currencies than bonds. This also explains the higher volatility that prevails in currency markets in most environments.

How does Bitcoin fit into this ‘pricing model uncertainty’ framework? After all, it is seen by many as a currency in its own right.

Bitcoin faces challenges because even the ‘weak’ forces that act as valuation anchors in traditional currencies, such as interest rate differentials, global trade patterns, and conditions in issuing currency are not in evidence. Without these drivers, Bitcoin is less like a currency and more like a commodity, subject to the laws of supply and preference-driven demand.

However, although supply is largely knowable, demand is not subject to the same dynamics as commodities like oil or metals. There is less relationship to activity in the real economy since no-one uses Bitcoin for productive purposes.

Over time, as the use value of Bitcoin does (or does not) establish itself, it may be possible to gain a sense of the fundamental drivers of this value and whether prevailing prices are reasonable or not. Until then, we are largely reliant on forecasting the tastes of others, and this usually comes with some volatility.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.