09.05.2022

Blog: Dot-com bubble and cryptomarkets

Blog: Dot-com bubble and cryptomarkets

Cryptomarkets have often been compared to the dot-com bubble. Is it a fair comparison, and can we learn something about cryptomarkets from the dot-com bubble?

              
How to identify a market bubble? The anatomy of market bubbles

Investment bubbles occur in the markets from time to time, either around a particular investment asset or sometimes even at the whole market level. But how can one identify these bubbles? The stages of investment bubbles are divided into five stages. These are: Displacement, boom, euphoria, profit-taking, and panic.

In the displacement phase, due to some narrative the valuation of the investment asset begins to rise and goes into overvaluation prices. Often the narrative states that the long-term profit potential on the asset is so high, that it is worth investing in it almost at any price level.

After the narrative takes hold, long term profits from the investment are seen as guaranteed. This lures in even more investors and starts the boom phase of the bubble. In the boom phase the price of the asset begins to grow even faster, and the rapid profits along the narrative lure more and more investors.

Fast growth and rapid returns create the euphoria phase of the bubble. A common phenomenon in the euphoria phase is FOMO (Fear of missing out), where investors, who aren’t even familiar with the asset end up investing in it, solely because of the fast growth that they don’t want to miss. Higher valuations are being explained with new narratives, and many of those who invested in earlier stages increase their positions inspired by the good returns.

At the top of the bubble some investors start selling their investments and this begins the profit-taking phase. At the beginning of this phase, there is often a sharp drop in the price of the asset, which many investors still see as a great buying opportunity. The large buy pressure will cause the price to make a short bounce upwards, after which more and more investors sell their investments while the price is still high.

When more investors move to the sell side, will this trigger the panic phase. The rapid fall in price makes the investors understand there is a bubble and thus the previous narratives stop working. In the panic phase the price of the asset falls rapidly as the bubble bursts. This phase also in the end reveals the good investments from the bad ones. Bad investment assets, often also born during the bubble, will go bankrupt or be forgotten about. Good investments on the other hand, while they might fall in worst cases almost 100% will find their bottom and base where they start growing again.

Bubble phenomenons

A very good example of an investment bubble was the tech-stocks dot-com bubble at the turn of the millennium. It is also the bubble that can be in some respects compared to the bubbles in the cryptocurrency markets. In terms of investments both markets are driven by a new revolutionary technology and its fast development and adaptation. After the mid-1990s, the fast adaptation of the internet and the opportunities it brought created a narrative of huge and rapid increase in productivity. Utilizing this narrative many companies that created business around the internet attracted huge amounts of investors and values of their stocks began to rise rapidly. The index of tech-stocks, Nasdaq, over quintupled between 1995 and 2000. The bubble finally bursted after the turn of the millennium, and many of the companies that were popular among the investors went bankrupt.

The main narrative around the dot-com bubble was the potential of the internet and how it will revolutionize everything. Although this narrative caused a bubble in the market, it is easy in retrospect to say that it was essentially true. However, as a result of this narrative, there were many companies created or listed whose entire existence was based solely on this narrative and the vision it created. An example of this is that when a companies added something referring to the internet into their names, like “online” or “.com” the price of their stock rose sharply in the stock market. This is also the reason for the dot-com bubble name. Investing in these new entrants is quite common in bubbles’ euphoria phases, where investors try to seek smaller and new investment opportunities, because they are perceived to have better upside potential than the largest drivers of the bubble.

There are easy to find similarities from the cryptomarket’s history. In 2017 the price of bitcoin rose from less than $1000 at the beginning of the year to a high of nearly $20000 in December. At the same time, many investors began to look for new investment opportunities with better return potential from smaller and smaller cryptocurrencies. Many new crypto projects appeared into markets gathering investors with vision only. This boom of new initial coin offerings (ICO) in the markets is often called the ICO-boom. At the same time, in the traditional stock market there was also a familiar phenomenon from the dot-com bubble, as companies added the word “blockchain” into their name, which multiplied their stock prices.

A good investment in a bubble

In both the Dot-com bubble and 2017 ICO-bubble one can find several examples of companies and projects that rose to wild valuations in their market cap but eventually ended up bankrupt or forgotten. On the other hand, in both bubbles one can also find so-called winners that have managed to stay clearly relevant even after the bubble burst.

Perhaps the most well-known company from the dot-com bubble today is Amazon. Although Amazon’s stock price rose sharply in the dot-com bubble it eventually fell over 90 % from its peak after the bubble bursted. At the top of the bubble the share price hit about 113 dollars, which it didn’t surpass again until 2009. In 2022, Amazon’s stock price has been around 3000 dollars, so not a bad investment even from the dot-com bubble top, if the investor has been patient enough.

There have also been winners in the cryptomarkets. Of these winners two clearest are also the two biggest Bitcoin and Ethereum. Bitcoin’s price collapsed more than 80 % from its 2017 highs but after the bottom it has clearly surpassed the previous top. Ethereum dropped more than 90 % from its 2018 peak, but it too has risen well beyond that peak.

It is easy to laugh at the losers of the bubbles after the fact, but how can one spot the winners in the bubbles or even after they burst? There are two major things combining the winners: utility, and development. Utility can be observed in the benefits that the company or the asset brings that goes beyond price speculation. For companies this means that they create goods and services to consumers, even though the valuation based on these can overshoot in the bubble. In cryptocurrencies it means use cases as usefulness. For example, bitcoins are used in global remittances and Ethereum is used as the platform for the huge DeFi ecosystem providing financial services globally.

The usefulness and adaptation of cryptocurrencies is accelerated with their development. Even though the development of large cryptocurrencies may seem slow due to their decentralizations, they are being developed constantly. DeFi and NFT ecosystems built on Ethereum have been growing rapidly during the last years thus creating more demand for ether also. In addition, Ethereum itself is moving from Proof-of-Work model to Proof-of-Stake, which is a huge change. One of the biggest developments in Bitcoin has been the Lighting network. It enables bitcoin transactions with almost zero costs, also making micropayments available with bitcoins. The Lighting network has also been a key part for example in El Salvador’s Bitcoin adaptation. With cryptocurrencies the development is also taking place in the activity growing around them. These include various cryptocurrency wallets, mining that encourages renewable energy, applications that utilize cryptocurrencies, social media tipping functions, and more.

Summary

There have been multiple different investment bubbles throughout history, from tulips to housing markets, and from tech-stocks to cryptocurrencies. Even if one can recognise the anatomy of an investment bubble, the bubble could be hard to accept due to irrational emotions brought by the bubble’s euphoria. However, if one has analyzed the investment asset and believes in it in the long run, a temporary bubble and its bursting shouldn’t change the investment decision a lot. The bursting of bubbles also gives opportunities to find those winners, to which the bubble will appear as a mere bump in the long-term development.

Manu Isto Cryptocurrency specialist
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Last updated: 09.05.2022 15:00
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