My Bitcoin Call, One Year Later

I often say that the least rewarding phrase to speak is, “I told you so.” Any time you have the chance to remind someone that you warned them something bad would happen,  point out that the bad thing warned against did in fact eventuate, and that they (or often, we) suffered a negative result because of their failure to heed your timely warning, it means a bad thing happened that might have been avoided. That sucks.

It is rarely a good thing when bad things happen, and suffering bad outcomes is not made better by the knowledge that they might have been avoided. That just makes it worse, because objective damage is compounded by emotional regret.

Right now I’m enjoying the rare circumstance where “I told you so” is a source of pure satisfaction, because none of those suffering the ill effects from failing to heed my advice are people I especially care about.

On January 5 of 2018, in this blog post, I stated the reasons I thought Bitcoin was in the blowoff phase of a classic bubble, and advised Bitcoin holders to immediately sell half of their position and reinvest the proceeds in assets with durable value, specifically US stocks, foreign stocks, and cash. (Real cash, not crypto-nonsense.)

Anyone who listened, and I have zero evidence anyone did, would have avoided a catastrophic loss. How big a loss? When my post went live, Bitcoin was worth $14,574 per coin. At close of business yesterday, it was worth $3,556. That is a 75% loss. You don’t need to help investors to avoid losing more than 3/4 of their wealth many times to justify your entire career as an advisor .

Last month I got an email from a guy at Morgan Creek Capital, announcing a new, diversified cryptocurrency fund. Since on the face of it this appears about as exciting as announcing a sale on luxury berths aboard the Titanic, a few days after that ship’s unfortunate encounter with the iceberg, his firm is offering a challenge to sweeten the pot, based on Warren Buffett’s famous wager against hedge funds.

Back in 2007 Buffett offered a $1 million bet to any hedge fund promoter who would take it. The hedge fund person would bet that a chosen basket of hedge funds would beat the S&P 500 over the next ten years. The winner could pocket the million, or (if Buffett won) donate the winning bet to charity.

Buffett won the bet going away. The S&P 500, with its low costs and inherent tax efficiency, also produced much higher economic returns, +7.1% annually for the S&P versus a lousy +2.2% for the hedge funds.

Recently Morgan Creek has suggested a similar bet, apparently failing to recognize the obvious outcome-by-analogy suggested by Buffett’s wager. I’ll help them out.

The trillions of dollars of actual wealth represented by the S&P 500, and the hundreds of billions of dollars of actual free cash flow produced by the companies in the index, have profound and (in the long run) growing economic value. Whereas cryptocurrencies are worthless and are likely to continue to decline in value.

I predict another big win for the S&P 500.

Bitcoin Bubble

Our office has been closed the last two days because of the winter cyclone that hit the East Coast. I’ve spent this unexpected time off reading and thinking about Bitcoin. I’m putting together a white paper that will pull my thoughts together in long format, but I think it may be useful to get a few tentative conclusions out there quickly, just in case things fall apart in the near future.

The nature of bubbles is that inexperienced investors think they are making huge money because they are smarter than everyone else. This illusion is self-reinforcing. It is why bubble pricing goes parabolic before it crashes. The reality is always that the late stage of a bubble is when the greedy and inexperienced make big profits, while the expert and experienced stand on the sidelines shaking their heads. And then it all falls apart, and perhaps one of twenty of the peak-era traders has actually gotten out with substantial wealth intact.

My opinion, as someone who has been running investments since 1978, and has seen bubbles in gambling stocks, precious metals, oil services stocks, tech stocks, shore real estate, residential real estate, tech stocks, shore real estate, tech stocks, residential real estate, tech stocks, and cryptocurrencies, and has correctly identified the last five or more of them, is that we are in the blow-off phase of the cryptocurrency bubble. I’ll develop this thesis further in the coming white paper.

So this blog post is aimed at Bitcoin hodlers (a deliberate misspelling with meaning to Bitcoin enthusiasts) who are sitting on significant wealth, and who are open to the possibility that they might, just possibly, maybe perhaps, be making a mistake by holding a large portion of their net worth in Bitcoin and/or other cryptocurrencies.

I have come to three semi-firm conclusions about Bitcoin and its variants (including Bitcoin Cash, Bitcoin Gold, Bitcoin Diamond et al) and competitors (including Litecoin, Ripple, et al):

  1. Blockchain is a powerful new technology, which is likely to have huge impact going forward, especially in those parts of the economy (brokerage, real estate, insurance) where assets are bought and sold, and their ownership tracked.
  2. Bitcoin innovated blockchain, but has no priority claim on using it. People can design their own novel blockchain applications and Bitcoin does not benefit. Indeed, competitors or would-be successors can duplicate Bitcoin’s software in every respect, make a few tweaks, and launch their own competing cryptocurrencies.
  3. We can’t know the future. Even you, Mr. Bitcoin Hodler. In one possible future, Bitcoin becomes as valuable as Netflix, Google/Alphabet, Amazon, or Facebook. In another, a different crypto makes it big and replaces Bitcoin. And a third possibility is that all cryptos become worthless, while the big money from blockchain applications will be earned based on another use-case entirely.

Which leads to one simple suggestion. If you are sitting on big money in Bitcoin, especially if you got in early and your net worth has exploded, even more especially if Bitcoin and other cryptos represent most or all of your portfolio, do two things:

  1. Sell half your holdings right away. Take the proceeds, hold back enough to pay the capital gains taxes, and invest equal amounts in three things: an S&P 500 Index, a global stock index, and a money market fund.
  2. With the remaining holdings, consider diversifying, again into three equal buckets: Bitcoin, a “portfolio” of three to five credible crypto alternatives, and a portfolio of public companies that are doing important work in the crypto space.

If Bitcoin is gonna be Google, and cryptocurrencies as valuable as the Internet, you’ll still get filthy rich, but not quite as rich as you might have. A billionaire, perhaps, instead of a multibillionaire. If some other crypto replaces Bitcoin as the future Google, you’ve still got a shot at owning it, and getting much richer than if you stay concentrated in what might end up a loser. And if the whole digital currency thing is not the second coming of electricity, the internal combustion engine, and the internet rolled into one can’t-miss digital asset, you’ve still got a chance for profits owning real companies that derive economic advantage from blockchain innovation.

If Bitcoin is in a stupid bubble, and loses 90% or more of its value, you will have changed your life, and you will be the envy of your techie friends who didn’t get out, even a little bit.

Either way you win. Fail to diversify, and there is a non-zero possibility you end up with nothing, or something close.

This is going to be real interesting to watch.


Buffett vs. the Technologists, Round II

“The historical track record of old white men crapping on new technology they don’t understand is at, I think, 100%.”

                                         Marc Andreessen, Venture capitalist and Bitcoin investor

Andreessen made his dismissive comment this summer at a forum discussing the future of Bitcoin, a crypto-currency I mentioned in a prior blog. The old white guy he was dissing was Warren Buffett, who had made some comments skeptical of the intrinsic value of Bitcoins.

Andreeseen was technically correct about Buffett’s predictive track record. He just had the value sign wrong. Buffett’s track record of forecasting the value of new technologies is indeed 100%, but the Sage of Omaha has been correct, not incorrect. Back in the late 1990s, Buffett published a comprehensive takedown of the technology bubble in Fortune magazine. At that time, tech enthusiasts dismissed him, indeed often ridiculed him for being old and out of touch. But Buffett was right. Investors in high-flying tech stocks lost most of their money as the tech-heavy NASDAQ index fell by almost 80% between March of 2000 and October of 2002.

Paying respectful attention to Warren Buffett is an intelligence test for any investor. So in trashing Buffett, was Andreesen ignorant, arrogant, or both?

The answer, I suspect, is neither. He was simply, as the tech world puts it, “talking his book.” (Thanks for that phrase, Mike.) Andreessen is a smart guy. He was one of the inventors of Mosaic, the first web browser, and a founder of Netscape. He reaped billions from his early tech career. Now a venture capitalist, he’s recently invested millions in the Bitcoin ecosystem — the range of companies working to provide support services to facilitate the deposit, spending, and transacting of Bitcoins and/or other crypto-currencies.

Most of what is happening around crypto-currencies is absolute nonsense, entirely reminiscent of past bubbles from the tech bubble to the original South Sea bubble in the early 1700s. (A new crypto-currency named after the tooth fairy? Really?) Will any part of the Bitcoin phenomena persist? Hard to say.

What is easier to understand is the overall track record of venture capital since the collapse of the tech bubble. Over the last decade and more, the return on venture capital as an asset class has been roughly zero. (As Jayne Cobb said, “Ten percent of nothing is, let me do the math here, nothing into nothing, carry the nothin’. Nothing.”) That does not mean there have no profitable new technologies. In fact, Andreesen was an early investor in Twitter, Facebook and other key tech plays. But it does suggest that, across the span of new business initiatives, the universe of venture capitalists have been unable to discriminate between promising and dead-end technologies, or perhaps between good and bad business plans. (Some successful first-generation venture capitalists, like Bill Janeway formerly of Warburg Pincus, refer to the approach of many current VCs as “spray and pray.”)

Back in 1997, the last time tech stocks were flying high, I went on a bike trip in France. One of the other cyclists was a famous venture capitalist, whose firm had bankrolled some of the most successful tech breakthroughs of the prior decades. At that time, he was contemplating leaving his firm and starting over, because his partners were not aggressive enough. He wanted to go into the freshman dorms at MIT to fund new Internet startups. Understand that he did not really think those freshmen were likely to have any genuinely valuable business ideas. He simply saw them as a source of new merchandise to peddle to the eager suckers.

This is a capital markets model, not a business model. I suspect part of the reason for the lousy returns may be that venture capitalists have gone from trying to invest in a broad range of technologies that solve actual human problems to trying to manufacture product for credulous investors.

Perhaps I am over-complicating the issue. It may be as simple as too much money chasing too few genuine economic opportunities. In any case, here at TGS we remain entirely comfortable have exactly zero direct exposure to venture capital as an asset class. Or as Jayne would say, “Nothing, carry the nothing. Still nothing.”

What is Money?

A few months ago, I had a conversation with another parent at my son’s school. The gentleman was an enthusiast for Bitcoin, a type of crypto-currency. I had a strong impression his interest was more than theoretical. He exhibited the sort of nervous energy characteristic of speculators hoping a large bet comes good.

Bitcoin’s origins remain obscure. In February, an energetic Newsweek reporter “outed” an unemployed electrical engineer, claiming him to be the source of the computer code that underlies Bitcoin. It appears that identification was wrong, and a lawsuit likely to follow.

Bitcoins create both benefits and problems on multiple levels. One obvious benefit is having access to a virtually untraceable form of buying power, outside the supervision of governments. This has appeal to terrorists, organized crime figures, folks with privacy concerns, and those who fear any government, including our own. (No, I’m not suggesting that Tea Party members are terrorists. I’ve never known any terrorist who walked around with a copy of the U. S. Constitution in his pocket.)

Bitcoin also has appeal for those not members of Al-Qaeda or the Russian Mafia. It is not fiat currency. The algorithm that creates new Bitcoins is designed to strictly limit the number in circulation, in theory preventing the inflation that gradually erodes the purchasing power of paper money in most countries. (Quickly, if you live in Venezuela or Argentina.)

Ironically, the anonymity of Bitcoins, and the lack of regulatory oversight, creates unanticipated risks. In February Mt. Gox in Japan, the largest trading exchange and depository for Bitcoins, sought Japan’s version of bankruptcy protection. Initial reports suggested the firm’s customers might have lost almost $500 million. At the time it went dark, Mt. Gox handled 70% of the world’s traffic in Bitcoins.

Another problem with Bitcoin as money is taxation. The Internal Revenue Service has determined that ‘spending’ a Bitcoin is a capital transaction. If the value is more than you paid, the result is a taxable capital gain.

The very name Bitcoin suggests the intention to create money, also reflected in the term ‘cyber-currency.’ So is Bitcoin money? In more general terms, what is money, and what do we want it to do for us?

The classic purpose of money is to be a medium of exchange. Instead of trading your two sheep for my ten chickens (which would require that you want chickens, and that I have some), you can sell me your sheep, receive cash, and spend that cash on other things you want, including goods that I do not possess. So far, so simple.

An ideal currency would be easy to use, widely accepted, and capable of being used to purchase goods anywhere in the world. By these measures, the U. S. dollar gets high marks. Perfect money should also be a stable store of value. If a sandwich cost $2 in 1980, you should be able to buy that same sandwich for that same $2 in 2014. By that measure, the U. S. dollar falls short. Inflation since 1980 has reduced the dollar’s purchasing power by 84%. (Still much better than the Zimbabwean dollar, which was abandoned in 2009 when inflation hit an annual rate of 6.5 quindecillion novemdecillion percent. You know you are in monetary trouble when you have to use words to save zeroes.)

The appeal of Bitcoin in part reflects dissatisfaction with the money otherwise available to us. The most significant defect of fiat currency like the U. S. dollar is its failure to preserve real purchasing power. Might Bitcoins have avoided that 84% loss in buying power?

Bitcoins weren’t around in 1980, but gold was. Anyone who bought gold in 1980, at the prior inflation-adjusted high, and held through the end of the 20th century, lost 69% of their nominal dollar value and over 90% of real value. Meanwhile, they missed out on a 2,427% bull market in U. S. common stocks.

Buying any asset at a time of euphoria usually works out poorly. How about if you bought gold when it was out of favor? If you had invested $10,000 in gold back in 1968 (illegal at that time in the U.S.), you’d have acquired 286 shiny ounces. Today, 46 years later, you would own the same 286 ounces of the yellow metal. In fiat dollars, the value of your holdings would have grown to $357,000; in real dollars, to $55,000.

So gold can be a successful or unsuccessful speculation, depending on price and sentiment, just like Beanie Babies, baseball cards, or penny stocks. But gold is not useful as money, because it does not reliably preserve real purchasing power, even if held for decades. If you had enough gold to buy a cheesesteak in 1980, by 1999 you might have been able to afford a pack of gum.

Does this mean we must ignore the erosion of wealth caused by long-term inflation? Certainly not. Warren Buffett believes that inflation will gradually confiscate the value of dollars over time. Thus far, he agrees with the goldbugs. But he believes the best hedge against inevitable long-term inflation lies in ownership of growing businesses, not shiny yellow metal. If you invested $10,000 fiat dollars in Warren Buffett’s Berkshire Hathaway in 1968, by the end of last year your shares were worth over $58 million. (Still fiat dollars.)

Would you really be happier to have assets worth $357,000, instead of $58 million, simply because what you held was not a fiat currency?

Saying you want only want physical currency is kind of like saying we should only permit live, not recorded music. Unfortunately, you cannot operate a modern international economy with physical metal, any more than you can carry around fifty symphonies and two thousand popular songs in the form of vinyl LPs. You need those countless trillions of ones and zeroes flying around the world over fiber-optics and copper wire to make the banking system work, just as you need digital data to make your iPod function.

Money is a medium of exchange, useful as a mechanism to make commerce work, hopefully with value that is not ephemeral. It is never an investment. Gold is lousy money in any modern economy, and is never a sensible long-term investment. In fact, gold is not an investment at all, since it produces no economic return. It is, always and forever, simply a speculation on future sentiment. Likewise, Bitcoins are no substitute for actual money, and have no intrinsic economic value. They may retain scarcity value, or they may not. What they most resemble is a kind of Ponzi scheme, since early “miners” of Bitcoins (presumably, those who created the underlying computer code) got lots of them dirt cheap, while later miners extract few coins at great effort.

Bill Gross had a recent comment on this whole issue of money. Conceptually, he suggests we think of all liquidity, including money, simply as diverse forms of credit. I’m not sure this entirely works. With borrowed money, there are two known parties, at least initially. Though once you add in credit-default swaps and securitization, maybe it is no longer possible to differentiate paper assets from real.

An aside — the night I met that other parent, Bitcoin was trading at over $1,000. Yesterday’s close was under $500, a more than 50% loss. Ouch.