“Cryptocurrencies are a bubble!”

Surely you’ve heard someone saying that, whether it is an economist or a non-specialist.

Between the end of the 1990s and the beginning of the 2000s, the world experienced an economic moment that became known as a “dot-com bubble”, a name that referred to the proliferation and overvaluation of Internet companies that, for the most part, were ill-founded and planned. On the Nasdaq stock exchange, this overvaluation is very well seen in the chart below, which shows the Nasdaq Composite Index (one of the indexes that measures the valuation of assets) from the late 1990s to the early 2000s.

The Nasdaq Composite Index variation from 1995 to 2010

What happened? “Dot-com” companies were a nonsense? No! Quite the opposite! Today we see the success of several technology and internet-based companies, such as Facebook, Google, Amazon, just to mention a few examples. What happened was that the investors, enthusiastic about a technological innovation with great potential for growth and therefore for financial profit, invested their money in all companies “dot-com” that appeared. This caused the so-called “bubble”. But over time, badly-grounded companies without a solid business model went bankrupt, which has made many investors fall apart. They were learning to invest in this market that until then was unknown.

What is happening today in the cryptocurrencies market is very similar to the “dot-com bubble”. After the pioneer of the crypto (a short term for “cryptocurrencies”) known as Bitcoin, hundreds of new crypto were developed as this new blockchain-based technology gained investor confidence and attracted the so-called “big money” as shown in the chart below. There, we can observe how the crypto listed on coinmarket.com since mid 2013's until the mid 2017’s have increased.

After the overvaluation of Bitcoin and other crypto at the end of 2017, there occurred a similar effect to the “dot-com bubble”, with a sharp decline in market value. Again, the same process happens: investors are enthusiastic about new technology, investing in everything that appears until they themselves realize that most of the assets they are investing have weak foundations. Again, there is a learning of the operation of a new technology and therefore of the new market generated by this technology, which in this case are the crypto and its framework called blockchain. This is evident in the chart below, which shows the value of some crypto (including Bitcoin) in US dollars in the period from mid-2015 to the end of 2018. There is a trend very similar to that of the Nasdaq Composite Index stock chart.

Price in US Dollars of the main crypto avaiable in the market

We can do a more sophisticated statistical analysis with both phenomena (the “dot-com bubble” and the “crypto bubble”) to get a hint about what to expect from the immediate future. Normalizing the both time series of the Nasdaq Composite Index and the price in US Dollars from Bitcoin, and shifting the time period, we obtain the following and very interesting chart shown bellow. I choose the Bitcoin as a referrence for this study because the other crypto have a good correlation and tends to follow the Bitcoin price trends.

There, we observe both peaks from both time series. The maximum value of the Nasdaq Composite Index occurs in december of 1999, while the max of Bitcoin occurs in december of 2017. The Nasdaq index starts in 1995, while the Bitcoin price in 2013. The resulting chart reiterates what I stated above, concerning the similarities between both market phenomena.

When plotted in a scattered chart for this shifted time period, we observe a strong linear correlation between the Nasdaq Composite Index and the USD price of Bitcoin. Evaluating the correlation coefficient, we obtain a correlation of about 88,40%! This result sustain the hypothesis that both economic moments are pretty similar in nature.

“But then answer me at once: are crypto a bubble, or are they not?”

No! Quite the opposite. What will happen is that, just as many crypto have been created, many will disappear over time because they have no foundations or a consistent business model. There is no way to know exactly which ones will persist in the market and which ones will disappear. However, some analysis may be done to suspect that a crypto is indeed a shitcoin. The fundamentals and principles must always be analyzed before any hasty decision, prevailing rule number one of investments: