Crypto-currencies Are Raw Human Emotion

If there's one noticeable trend that is going through a massive wave right now it is most certainly the crypto world. Due to its crazy dynamics and underlying setup, crypto-currencies might be the best example of human emotions mixed with investing since the tech bubble. It also might go down as one of the biggest booms and busts in the entirety of financial market history--on par with the Tulip Mania, Japan, and the South Sea Bubble.

The peak market cap of the major crypto-currencies reached over $800 Billion in January 2018. For some perspective, that's larger than the entire economy of countries like Turkey, the Netherlands, and Switzerland. It's bigger than the combined economies of Nigeria, South Africa, and Kenya. It's bigger than Google, Microsoft, Amazon, or Berkshire Hathaway. All in bits and bytes that don't provide any revenue or production whatsoever! If that's not raw human emotion and madness of the crowds, I don't know what is.

Two of my favourite books, and must-reads for any serious investor, are Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay and Devil Take the Hindmost by Edward Chancellor. While Chancellor's book focuses almost exclusively on financial markets, Mackay's book also includes topics from fashion trends to fortune telling. They are great reads on crowd psychology--a very important factor in successful trading.

Crypto Factors

While I have done a decent amount of reading trying to understand Blockchain technology, I still don't entirely grasp the whole concept of the associated coins (or tokens) and why they carry some significant valuations. Sure, Blockchain has the potential to be game changing in terms of contract making, record keeping, legal tracking of property rights and ownership, and money movement.

I think the Ethereum platform in particular is doing some very cool things in these areas and more. Perhaps not ironically, Ethereum's co-founder and chief brainiac Vitalik Buterin (a fellow Canadian) is one of the biggest critics of high valuations for crypto-currencies.

So... while Ethereum is busy downplaying the valuation of its associated tokens and is doing cool things, the biggest crypto-currency--Bitcoin--has always seemed a whole lot more shaky to me. I've found Bitcoin to be strange in its allure and freakishly fraudulent in its promotion. It's actually the perfect fraud in many ways with all kinds of big red flags waving in your face: it's unregulated, the real coin holders are not traceable, invest is heavily promoted to the public by people with a vested interest, the platform has created an illusion of scarcity, and it's been adopted by a generally uneducated, inexperienced public market (in an investing sense, of course). Consistent with other famous bubbles, the higher it went the more outlandish the claims of valuation became. Predictions of Bitcoin $5,000 somehow became Bitcoin $1,000,000.

Another strange concept is the underlying valuation arguments for Bitcoin. The idea that a currency written by computer code and horded by its buyers can somehow be truly scarce is absurd. Yes, I understand the code only permits around 21 million Bitcoin to be released, but it's still just computer code and entirely non-tangible.

If some investors argue gold as a currency is useless, Bitcoin as a currency is really, really useless. At least gold looks pretty, has some industrial and jewelry usage, and is tangibly scarce making it a great representation of a store of wealth. Nevermind the fact that gold has been used as a currency and to measure of wealth for thousands of years. The suggestions that Bitcoin is a form of digital gold is totally insane.

What does Bitcoin really do and what value does it bring? Hell, the most valuable part of the whole thing, the Blockchain ledger concept, is open-source and free for anyone with moderate to great programming skills to copy and modify for their own use as they see fit. By nearly every metric, there are other Blockchain platforms which are now much better than the Bitcoin platform in every way.

The only other valuation argument, the cost of "mining", is also a type of Ponzi scheme in itself. The more popular Bitcoin becomes, the more miners jump on board to process transactions, the more expensive the mining process becomes. Nevermind the insane amounts of electricity and computing power being wasted.

I don't know and I won't pretend to know where Bitcoin will go from here. I think there are two very real possibilities over the next few years: 1) Bitcoin holds its own and makes new highs, or 2) Bitcoin grinds its way down to nothing.

One thing that Chancellor and Mackay's books so clearly established is that Financial Bubbles are entirely unpredictable. Human psychology and emotions, especially when it comes to money, can be irrational for a long time. Betting against human emotions is a very tricky and dangerous game. This leaves just one reasonable way to make money from crypto-currencies: trading.

"The market can remain irrational longer than you can remain solvent." - John M Keynes

Trading Bitcoin

I admit that I missed a huge trading opportunity with Bitcoin (and other cryptos). While its easy to have regrets about the things you don't do, I will stick by my strategy and conviction only to invest in liquid instruments in which I have some understanding.

I still don't really understand Bitcoin as a currency, which is one big issue that kept me away from it. Another big problem is liquidity. Until recently, there was no way to trade Bitcoin in a liquid environment for a reasonable cost. The popular wallets seem prone to hacking problems and their transaction fees were way too high.

I wouldn't trade stocks or ETFs if my brokerage was hacked every few weeks and liquidity dried up every time my system called for a sell signal. By that logic I also shouldn't trade cryptos.

However, there were some amazing profit opportunities in Bitcoin over the past few years and I thought it would be fun to take a look at the charts and see where the trading opportunities would lie. Due to the volatility in Bitcoin, I used a 20-week (similar to 100-day) EMA to keep the stops tighter to the price.

Full Bitcoin Chart with No Signals (July 2010 to March 2018)

Source: Yahoo Finance

I find this chart to be very interesting it itself. Bitcoin started at around US$0.05 per BTC. Looking at this chart from a logarithmic perspective (arguably the only way you should look at returns over time), you can see that Bitcoin did much better in the first half than the latter half. From 2010 to 2013, the price expanded from $0.05 to $1,241--an increase factor of 24,820!

From that peak until the next major peak in 2017, the price only increased from $1,241 to $19,870--an increase factor of 16. Still incredible of course, but you can see here that the real money in buy-and-hold was made at the start. The individuals who got into Bitcoin before the end of 2012 would have been able to accumulate massive amounts of Bitcoin for low overall cost. I would consider those buyers to make up the majority of the inside crowd because they control large chunks of the total Bitcoin supply.

Beginning in 2013, Bitcoin made its first big run. This is also around the time that I first heard about Bitcoin.

2-Year Bitcoin Chart with 20 Week EMA Signal (2013 to 2015)

Source: Yahoo Finance

The 20-week Exponential Moving Average is the highlighted blue line. This time period captured the first major move in Bitcoin. In 2013, the price started at $14 per BTC and ran up to $1,241 by November. However, by the end of 2014 the value had fallen back down to $264--a near 80% decline!

2-Year Bitcoin Chart with 20 Week EMA Signal (2015 to 2017)

Source: Yahoo Finance

In this next two year period, Bitcoin was in a drawdown for the entire time! Bitcoin finished 2016 at around $900 per coin. Still lower than the peak in 2013. Anyone who was HODLing Bitcoin would have chewed their nails down to nubs by the time the price hit a low of $157 in the beginning of 2015--a huge 87% peak drawdown. But things slowly improved from there. As we'll look at later, a trader could have made some nice profits in this time period.

2-Year Bitcoin Chart with 20 Week EMA Signal (2017 to Current)

Source: Yahoo Finance

This last period includes the latest run-up in Bitcoin. Once Bitcoin crossed $1,000 again in the beginning of 2017, things started to get really heated. Trading volume exploded from a few hundred million trades per week to tens of billions of trades. Considering there's a total of 21 million coins, about 17 million of which are in circulation and most of them hoarded by insiders, the trading volume is absolutely insane. This is raw human emotion at work here and it makes for a great case for trading using careful rules.

Trading Bitcoin with a Simple System (2013-Current)

Lets look at how a trader could trade Bitcoin in their portfolio using some very simple, rudimentary trading rules.We'll use the same 20-week EMA for signals. We'll assume the remaining part of the portfolio is in cash to keep the calculations straightforward.

Scenario and Rules
Starting Portfolio Value: $100,000
Maximum Entry: 10% of portfolio value
Trading Frequency: Weekly

Trades and Portfolio Value
Trade 1 on Jan 1/13: Buy 714 BTC at $14, $90,004 cash, total portfolio $100,000
Trade 2 on Jun 30/13: Sell 714 BTC at $76.50, total portfolio $144,625
Trade 3 on Jul 7/13: Buy 153 BTC at $94.42, $130,178 cash, total portfolio $144,625
Trade 4 on Feb 2/14: Sell 153 BTC at $659.57, total portfolio $231,092
Trade 5 on Mar 2/14: Buy 36 BTC at $627.05, $208,518 cash, total portfolio $231,092
Trade 6 on Mar 16/14: Sell 36 BTC at $551.16, total portfolio $228,360
Trade 7 on May 18/14: Buy 40 BTC at $570.44, $205,542 cash, total portfolio $228,360
Trade 8 on Aug 10/14: Sell 40 BTC at $485.50, total portfolio $224,962
Trade 9 on Jun 28/15: Buy 83 BTC at $270.14, $202,540 cash, total portfolio $224,962
Trade 10 on Aug 2/15: Sell 83 BTC at $263.87, total portfolio $224,441
Trade 11 on Oct 11/15: Buy 85 BTC at $261.67, $202,199 cash, total portfolio $224,441
Trade 12 on Jan 28/18: Sell 85 BTC at $8,218.05, total portfolio $900,733
Trade 13 on Feb 11/18: Buy 8 BTC at $10,417.23, $817,395 cash, total portfolio $900,733
Trade 14 on Feb 18/18: Sell 8 BTC at $9,610.11, total portfolio $894,276
Trade 15 on Feb 25/18: Buy 7 BTC at $11,504.42, $813,745 cash, total portfolio $894,276
Trade 16 on Mar 4/18: Sell 7 BTC at $9,544.84, total portfolio $880,559

This is a great example of how you can profit enormously when trading, even with very simple risk parameters. It's probably fair to point out the level of risk in this system is still too high for me personally. I would limit my entry to something like 5% of the the total portfolio, but I also wouldn't have the rest of the portfolio in Cash.

In my example, assuming the rest of your portfolio made no returns, your portfolio would have jumped from $100,000 to $880,559 in just five years--a compound annual return of 52%.

Another interesting fact is only 50% the trades were profitable while the rest resulted in small losses. This rate of successful trades is common in trading systems. It demonstrates that you don't need to be right all the time, you just need a system and proper risk management.

An observant idiot would look at this example and say, "Yeah but if I would have considered Bitcoin as my 'play money' and HODLed the 714 BTC from January 2013, I would be worth $6.2 million right now!"

Sure, hindsight is always perfect in theory. But how would you have reacted through the 87% drawdown after the 2013 run? Or the 55% drawdown we're in right now? That's risking an enormous amount of your capital on one shaky asset. I'd take the 50% annual returns along with my sanity, thank you very much.

Trend following and risk controls are the path to sustainable wealth over long periods of time. HODLing anything, especially without very good diversification, is relying on wishes and prayers. We call that gambling, not investing or trading.

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The Year of Easy Wins

This will be my last post of 2017. My next post will be in January starting with our regular monthly updates.

The Year Everything Goes Right

Let's be honest, 2017 has been another amazingly easy year to make money investing. It seems just about everything has gone up, even in Canadian dollar terms (our dollar rose a few cents on the year which reduces the gain on international investments).

U.S. stocks are up around 15%, developed markets are up 19%, Canadian stocks are up over 7.5%, emerging markets are up 21%, even bonds are up 2-3% in our rising rate environment. To top it all off, volatility has been incredibly low with the VIX below 20 for the entire year. That's unprecedented stability!

If you were starting out this year and simply bought XAW.TO, taking a stake in over 8,100 companies around the globe, you would have made an easy 17% this year! It would have been free to purchase if you used Questrade as your low-cost online brokerage.

We’ve also been hit by crypto-mania. You could have bought any number of “currencies” like Bitcoin, Ethereum, Litecoin, Bitcoin Cash, Bitcoin Gold, Ripple, NEO, Zcash, Stellar, Waves, Qtum, and a myriad of other names and tripled or even 10x your investment in mere months. (Yes, these all and many more have market caps over $1 billion). You can't make this stuff up.

Millions of people who can barely keep their iPhone properly updated and their laptops virus-free are putting their life savings into fictional digital money. Some boldly pretend to understand the ins-and-outs of this technology and justify its value; most are just blindly chasing the crowd.

A Reality Check

All this investment dreamland stuff calls for a bit of a reality check. I don’t mean to scare people from investing, taking smart risks, or saving aggressively for retirement. But realize that it isn’t going to stay this easy.

Stock markets and bond markets go through cycles which average out to a long-term return of around 3% to 7% depending on the investment mix and corrected for inflation. It’s impossible for the broad market to give returns much higher than that for an extended period of time. A few years in a row of +10% or +20% returns are always followed by a year or more of -20% or -40% returns.

Given that we’ve had a wicked good run since the beginning of 2016, and really since spring 2009, it’s only reasonable to believe this bull market will come to an end and stocks will undergo another severe correction at some point. Right now a return to average valuations for U.S. stocks requires a 60% drop!

I’m not saying it will be in 2018. In fact, the numbers are looking so good that many “experts” are already suggesting 2018 will be another banner year. We’ve got Trumpian tax cuts, big government spending, record corporate profits, inflation and wage gains, and public legitimized trading of cryptos to propel the markets forward forever.

Of course, the experts also saw no risk investing in mortgages for bankrupt, jobless people in 2007, or investing in perpetual money-losing tech firms in 1999 based on website eyeballs.

Socioeconomic Problems

Despite having some of the lowest unemployment rates in modern history, with historically low unemployment for some time now, many are suggesting we have just entered a new economic boom. As if things were so terrible from 2011-2016.

Some are still under the illusion that we need to have growth rates of 4% or more in the developed world. This despite low birth rates, the economic drag of an aging population, out-of-control spending, and a voting public that expects super-low tax rates but blindly dives into debt.

From the beginnings of time, parents and grandparents demanded a better future for their children. Now they put the burden of their selfish desires on the next generation. Insane public health care services, social security, OAS, CPP, tax cuts, and lucrative pensions are enjoyed by older generations today.

Meanwhile the adults of tomorrow are saddled with record student debt, over-priced housing, and trillions in government debt and future social obligations. Historically these things tend not to shake out too well.

If you are young and contributing to a defined benefit pension plan today, don’t foolishly count on it being there for you in its promised form when you are ready to retire yourself. Even the most coveted government pensions are in deep trouble. After nearly a decade of incredible investment returns, there is hardly a pension out there which is fully funded in actuarial terms. A large drop in global asset valuations would do incredible damage.

Investing With Caution

Now more than ever is a good time to invest with caution. This isn’t being fearful; it’s being smart.

Follow a disciplined investment strategy that has proven to perform in down cycles. Trend investing and Dual Momentum strategies are reasonable choices.

You should hedge against the downside risks that are always very real. This means putting in wide stop-limit orders or tracking stops yourself to get out of your investment positions methodically if prices fall.

If you’re a more advanced buy-and-hold investor, use 0.5% of your portfolio to pick up some six-month forward out-of-the-money SPY or QQQ puts and roll them every quarter. They’re as cheap as they’ve ever been right now and a good form of portfolio insurance costing 1% or less of your total portfolio.

Having A Moose Mentality

All this said, I don't spend a lot of time worrying about these risks; you shouldn't either. It's easy to follow a plan where you check your brokerage account only once or twice a month and go on living your life for the rest with an eye to a promising future. I do it, so can you.

I believe in the importance of looking after myself first. That means being financially responsible, cutting out the frivolous crap in life, and slowing life down wherever possible. It means looking after my physical and mental well-being. Stress is a choice and I choose 'No'.

In a world where money is the biggest cause of chronic stress, hopefully the nuggets of info every week on this site have helped you say 'No' to money stress as well.

This season, commit to being generous to those you actually care about—family and friends. I challenge you to pick up the phone and cancel your regular donation to that faceless charity who knocked on your door years ago. I bet you don't know where your money actually goes and the accountability is often shaky.

Instead, look around to the people that matter to you and see where you can help. It might be a grocery gift card to the friend that was laid off, a few weekends of your time helping someone save thousands repairing their house or vehicle, bringing a warm meal to someone who is sick, or sharing a cup of coffee at home listening to a friend's concerns and showing them your love. That's the best kind of charity. Use your talents to form the community you want to be a part of.

This Christmas season my wife and I will be trekking a few thousand kilometers to be with our families. We'll share laughs and squabbles, eat like kings and regret it, drink too much and wake up lousy, be active but still gain a few pounds, enjoy the outdoors and relax.

Wishing you and your family a Merry Christmas and fantastic holiday season!

- Daren

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing promo links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.