Since the trough of the Great Recession in March 2009, the broad-based S&P 500 has returned nearly 300%. This is among the best intermediate-term returns that investors have ever seen, considering that the stock market averages a 7% historic annual return, inclusive of dividend reinvestment and adjusted for inflation.
But cryptocurrencies have one-upped the stock market. In fact, you could argue that the smorgasbord of virtual currencies has left the stock market eating their dust. Since the year began, the aggregate market cap of all cryptocurrencies has increased from $17.7 billion to north of $300 billion as of Nov. 29, a return of close to 1,600%. These are lifetime gains that cryptocurrency investors have enjoyed in just 11 months’ time (assuming they’ve held since the year began).
Explaining the swift move higher in virtual currencies
It’s hard to pinpoint a single reason why digital currencies have exploded higher. Rather, it looks to be a combination of factors that’s led to their ascent.
First and foremost, there’s a lot of excitement surrounding the blockchain technology that underlies most digital currencies. Blockchain is the digital and decentralized ledger responsible for recording all transactions without the need for a financial intermediary. These open-source networks are deemed to be especially secure since it would be difficult to alter logged data without someone else noticing. This technology has the potential to be a game-changer for the financial services industry.
Folks are also pumped about the use of virtual tokens as a form of peer-to-peer and business-to-business payment. A handful of brand-name businesses began accepting bitcoin (BTCUSD=X), the world’s most popular cryptocurrency, back in 2014, and the number of merchants that accept it has only grown since. Online retailer Overstock.com is perhaps the biggest pioneer of cryptocurrencies, accepting bitcoin, Ethereum, Ripple, Litecoin, Monero, and Dash.
We’ve probably also seen a fair bit of “FOMO,” as the financial news networks will describe it. FOMO stands for the “fear of missing out,” and it describes the emotional pull of investors to dive into a rapidly appreciating asset for fear of missing out on big gains. With bitcoin galloping higher by more than 1,000% in 11 months and surpassing the market caps of companies like General Electric and Walt Disney, investors simply don’t want to miss the boat.
Two reasons it’s impossible to properly value cryptocurrencies
But for each crypto-enthusiast, there’s a skeptic arguing that this move higher in virtual currencies is nothing more than a bubble. And the thing is, these skeptics could be right. They may also be wrong. We simply don’t know because valuing bitcoin, Ethereum, Ripple, Litecoin, and other extremely popular cryptocurrencies is veritably impossible for two reasons.
1. You can’t bet against cryptocurrencies (at least not yet)
To begin with, you can’t “make a market” out of virtual currencies. This means that investors don’t have the opportunity to exploit the downside potential in bitcoin, Ethereum, Ripple, Litecoin, or other digital currencies by betting against them.
With stock-based equities, retail and institutional investors have the opportunity to short-sell or purchase options betting on a move lower. This allows investors of all opinions an opportunity to make money, regardless of which way a stock-based equity moves.
By contrast, virtually the only option investors have with cryptocurrencies is to buy or sell. There are no mainstream short-selling or put contract options to choose from. Perhaps the one exception might be the Bitcoin Investment Trust (NASDAQOTH:GBTC), which holds a relatively fixed amount of bitcoin month to month. Investors do have the opportunity to short-sell the Bitcoin Investment Trust in order to bet against the price of bitcoin (vis-a-vis the net asset value of the Trust’s holdings). Still, few avenues to establishing a fair market value exist.
This could soon change with bitcoin. In late October, CME Group (NASDAQ:CME) announced its intent to begin offering bitcoin futures before the end of the year. While the news is exciting in that it could introduce new money from institutional investors who’ve largely been on the sidelines, it’ll give investors their first real opportunity to bet against bitcoin. But this windfall of new money for CME Group could lead to tears for bitcoin investors.
2. You’re not really “investing” in virtual currencies
The other reason it’s nearly impossible to value bitcoin, Ethereum, Ripple, Litecoin, and their peers is that you’re not really “investing” in these assets since they’re not backed or tracked by anything in particular.
When you purchase stock in a company, you gain partial ownership of that company, no matter how small your stake. There are also balance sheets, earnings reports, and filings with the Securities and Exchange Commission that investors can use to help determine an appropriate value for that equity.
This isn’t the case with virtual currencies. Buying tokens does not give you a stake in the blockchain technology that underlies bitcoin or Ethereum, which is where most pundits suggest the value truly lies. Furthermore, since these currencies have no government backing, there’s practically nothing tangible to base their moves up or down on. News-driven events, such as a new retailer accepting their tokens, can provide a boost, but it’s not exactly the tangible evidence that investors are usually looking for when valuing an asset.
Whereas futures trading might be able to solve the concern described above, there’s not really a fix for this issue, given that decentralization is at the core of the virtual-currency movement.
Long story short, expect volatility to remain nauseatingly high and for cryptocurrency “valuations” to make little sense to traditional investors.
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