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Are We In a Crypto Bubble?

A financial bubble is a situation in which asset prices are much higher than the underlying fundamentals can reasonably justify. Is this the case for cryptocurrencies ?

Bubble is a term that has been thrown around loosely in the financial media over the last few years to describe everything from the housing market to equities to used cars.

With the Federal Reserve pumping trillions into the economy and keeping the short-term federal funds rate low in response to the COVID-19 crisis, real estate and stock prices have skyrocketed.

While it's true that stock market valuations have become stretched by traditional metrics and that the real estate market has arguably never been hotter, it’s hard to say whether or not these assets are actually in a bubble or if the financial landscape has simply changed.

Then you have cryptocurrencies – a burgeoning asset class that created life-changing wealth for early investors during the pandemic.

Digital currencies like bitcoin and ethereum, the two largest cryptocurrencies by market value, have had meteoric ascents since 2019 that has left some under the impression that the entire crypto market is a massive speculative bubble.

One reason people likely piled into cryptocurrencies during the pandemic is because they can be traded from anywhere in the world 24/7, which means they are liquid and decentralized assets that don’t rely on any single central bank or government. 

Large-scale institutional investors began adding exposure to crypto markets during the pandemic as well, with legendary investors like Paul Tudor Jones openly endorsing these fascinating financial instruments.

Then you have the concept of FOMO, or fear of missing out, that helped to drive crypto market prices to continuous record highs.

Cryptocurrency Bubble Lead

Add to that government stimulus checks and people stuck at home practicing social distancing and you have the perfect recipe for speculative mania. 

As we head out of the pandemic, many investors are wondering if the rapid ascent in crypto markets was simply a product of excess liquidity in the financial system.

On the other hand, there is an argument to be made that cryptos are truly a viable asset class powered by cutting-edge technology that could transform the way people think about money forever.

Only time will tell which narrative is correct, but there are definitely some concerns that crypto investors should be aware of going forward.

Let’s take a look at some of the signs which could suggest a crypto bubble is hiding in plain sight.

The Case for a Crypto Bubble

Crypto bears have plenty of ammunition supporting the idea that there is a massive crypto bubble. 

It helps to take a high-level view of these volatile assets and consider what exactly their purpose is.

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Bitcoin, the most popular cryptocurrency in the world, is lauded as a private and decentralized digital currency that has numerous advantages over fiat currency, yet due to substantial volatility, it has more in common with high momentum stocks than currencies like the U.S. dollar. 

These digital currencies have massive price swings on a regular basis, which means they aren’t exactly a reliable store of value.

They are also easy to replicate since all it takes to create a new cryptocurrency is some basic coding skills. There are currently over 12,000 different cryptocurrencies in circulation, according to data firm CoinGecko.

Crypto investors got a recent reminder of just how quickly prices can move as the crypto market shed more than $1.2 trillion in market value since hitting all-time highs early November.

Historically, bubbles move in five stages – displacement, boom, euphoria, profit-taking, and panic.

One could argue that the profit-taking has begun, and it will be very interesting to see how crypto markets continue to hold up as the Federal Reserve moves ahead with tightening its monetary policy to combat inflation

Frothy Valuations in Crypto Startups

It’s also important to consider how the ballooning valuations of crypto startups like FTX and OpenSea could be a sign of a bubble. 

FTX, which is a Bahamas-based crypto exchange, saw its valuation jump from $25 billion last October to $32 billion in early February.

While the company has indeed been experiencing rapid user growth since its last round of funding, such a rapid increase conjures up memories of the dot-com bubble when almost any tech company received a massive valuation.

OpenSea, which is the world's largest non-fungible token (NFT) marketplace, is valued at $13.3 billion, a staggering figure for a company formed in 2017 and operating with a staff of 90 employees. 

NFT sales reached $7 billion in January, an all-time high, yet many of these transactions were wash trades, which is when a seller purchases their own product to generate artificial demand and essentially manipulate the price of their assets.

That is not exactly the type of activity that inspires confidence.

It’s hard to shrug off the idea that a bubble is hiding in plain sight when you have such frothy valuations for crypto companies and pixelated images of “CryptoPunks” NFTs selling for $23.7 million. 

The Ultimate Test for Cryptocurrencies

There have certainly been some recent warning signs that crypto markets could be headed for a prolonged bear market, and it’s safe to say that 2022 is going to be a defining year for the future of this up-and-coming asset class.

Is the crypto bubble about to burst as liquidity dries up in the financial system? 

Or will investors add more exposure to these limited-supply digital currencies this year to potentially hedge against inflation or capitalize on the growing number of real-world uses for crypto and blockchain technology?

One thing’s for sure – early crypto advocates have been rewarded handsomely for having faith in this new technology. 

Market bubbles tend to end badly for investors that are late to the party, so investors should definitely keep in mind the risky nature of cryptos if investing at this time given the possible red flags discussed above.

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