Bitcoins, Bubbles, And Beanie Babies

Yesterday the U.S. Department of Justice announced the arrest of two individuals affiliated with “bitcoin” exchanges. The two men are charged with using the bitcoin exchanges — which allow people to trade bitcoins for currency like U.S. dollars — to obtain bitcoins that could then be sold to users of another on-line exchange, called Silk Road, where the bitcoins could be used to buy drugs anonymously, in violation of the Bank Secrecy Act.

Bitcoins are a kind of token to which some people have assigned value. Each bitcoin is represented by a supposedly unique online registration number, created when a computer solves a difficult mathematical problem with a 64-digit solution. There are supposed to be a finite number of such 64-digit solutions and therefore a finite number of bitcoins, which is why bitcoin investors believe they will only appreciate in value. Users receive bitcoins at unregistered, anonymous addresses, which means the bitcoins themselves can be used to conduct anonymous transactions, as a kind of on-line currency. And, as the announcement yesterday reflects, bitcoins can be traded for real money.

I don’t pretend to fully understand bitcoins and how they are supposed to work — but I wonder how many people who have them and use them really do, either. It’s hard to understand how real value could be created simply because a random computer solves a complex math problem, and I expect that many bitcoin investors don’t have the mathematical and computer capabilities to really understand whether bitcoins are truly unique and just how limited their supply really is. And the anonymity of bitcoins means there is plenty of opportunity for mischief in how they may be used.

People who trade in bitcoins and are banking on their appreciation in value are taking a lot on faith. Of course, at a certain level you can argue that every form of currency involves a similar act of faith, but at least there are public, functioning markets for U.S. dollars, Treasury bills, stocks, and bonds and they are backed by functioning, publicly known entities. Bitcoins remind me of subprime mortgage bundles, or for that matter Beanie Babies. For a time, each of them was a hot commodity. Everyone seemed to be buying them and the word on the street was that their value was only going up. Then one day the frenzy ended, people stopped buying, and the investors were left with pieces of paper or a pile of children’s toys — and a big hole in their balance sheets and bank accounts.

Maybe bitcoins will be different . . . or maybe they won’t.

Bursting Bubbles

With the wild stock market swings in recent days I thought it might be helpful to recommend a book I just finished today, The Great Depression Ahead by Harry Dent.

It is an excellent book which is simple to understand that everyone who is an investor should read with an open mind of course. Mr Dent is a long term stock market bull who predicted the technology boom and it’s demise and turned bearish a few years ago. He is predicting Dow 3500 – 3800 between now and 2014.

The premise of the book is that simple trends drive long – term growth and that changes in demographic and technology cycles are critical in predicting business and economic trends. He mentions that government intervention (QE2, stimulus etc) can sometimes delay, but won’t be able to overcome the massive baby boom generation productivity, earning and spending power that have now peaked.

He uses data going back to the mid – 1800’s to come up with three different cycles – the 80 year lifetime cycle (last peaked in 1930), the 40 year generational cycle (when generational spending was at their peak in 1930 – 1970 and 2010) and the 30 year commodity cycle (that peaked in the years 1890 – 1920 – 1950 – 1980 and 2010) all converging bubbles that are popping at approximately the same time 2010 to cause an upcoming major stock market crash.

It’s his opinion that a diversified portfolio which we are all taught to have will not be able to withstand the coming stock market crash and that only cash and high yield bonds will fair well in the near future. Mr Dent believes there will be bear market rallies until 2020 -2023 at which time a new “boom period” will emerge.

My next read is going to be Aftershock by David Wiedemer, Robert Wiedemer and Cindy Spitzer, all economists who are predicting a more radical market meltdown then what Mr Dent is predicting.