At this time, there is a rare concurrence of opinion among students of financial markets that a serious disconnect exists between prices and reality. What is meant by that is that prices suggest a cloudless sky ahead, while economic realities are waving warning flags. To understand this, let’s look at the concept of “intrinsic value”.
Consider a bond. If you own one, you receive a series of fixed interest payments and an eventual repayment of principal. The intrinsic value of the bond can be calculated via a simple discount formula, using whatever rate of return you seek on your investments. Should you want to sell, the actual price of the bond, however, depends on discounting at the current market rate of return. Consequently, price and value are not necessarily the same, although they are usually close.
With a stock, you own a piece of a real company that makes and sells things or provides a service. If you are a shareowner, you get a series of variable dividends (maybe) and some profit (hopefully) when you eventually sell. You can calculate the intrinsic value just like a bond, but you have to make some assumptions about future dividend payments and the future profitability of the company. Comparing this intrinsic value to today’s price tells you whether the investment is likely to prove satisfactory or not.
If you invest in commodities that are used to produce things (e.g., copper, oil) or are consumed as food, they clearly have an intrinsic value based on anticipated supply and demand.
Turning to things like art, jewelry, and gold, they have a perceived value, but it is not possible to calculate intrinsic value since fashions change, and today’s hot item may be seen as less valuable tomorrow. Gold, however, has a long history of desirability, as do various gemstones like diamonds, emeralds, and rubies. Their perceived desirability is assumed to be something that can be counted on to persist. But at what price? Because any of those tangible assets has a price of X today, why should we assume that its price will be higher tomorrow? The supply and demand balance does not change appreciably over time.
Gold does have commercial uses, but its primary function is as a store of value, and as an alternative to paper money. Nevertheless, there is no absolute link between the value of gold and the fortunes of the dollar. At one time there was an apparent link between the price of an ounce of gold and a barrel of oil, but that relationship has been unstable for some time. Gold and oil have intrinsic value, but what that value is in terms of dollars varies greatly. If we eventually go to a carbon-free world, oil will lose much of its intrinsic value. Nevertheless, as long as people covet bright shiny gold, it will retain intrinsic value, but what we can’t say with certainty is that an ounce of gold has, or should have, an intrinsic value of $1,000 an ounce, or $2,000, or $10,000.
If the intrinsic value of the dollar declines (i.e., buys less) due to inflation caused by wrong-headed Government action, there is no certainty that a tight correlation with the price of gold will be maintained. In the financial panic of 2008-9, the price of gold fell even as economic conditions suggested that it should have risen in a “flight to safety”. The price of gold will be whatever people are willing to pay for it.
That brings me to Bitcoins and cryptocurrencies generally. Despite pictures often displayed in ads, there is no physical thing called a Bitcoin that anyone can pick up and hold. It is what in Philosophy 101 is called a “mental construct”. It exists because people act as though it is real, but it is not a physical “thing”. What is its value? It has no intrinsic value, just a price associated with it. You can buy and sell a cryptocurrency, but what you cannot do is put it in your pocket. All you can do is put a piece of paper in your pocket that says you own so many of them. CNBC will tell you what people are paying for them at the moment, but when they are bought and sold all that happens is that the buyer’s account has more and the seller’s less. There is no anchor to the real world whatsoever, even if Elon Musk will accept them as payment for one of his cars.
At some point, the music stops, and holders of cryptocurrency will ask, “What the hell do I actually own here?” It is not a shiny piece of gold or a brilliant gem. It is not a legally enforceable promise to pay (like a bond) or a share of a company’s assets. It is not a piece of paper money backed by the Government’s ability to levy taxes. It is an intangible asset that can only be converted into something real if someone else is willing to accept it as a medium of exchange (i.e., money). And how does Elon Musk decide how many Bitcoins he will ask for one of his Tesla cars? With a cryptocurrency like Bitcoin going up and down by 5% a day (or 20% last weekend!), you can’t manage a business when you don’t know the value of your liquid assets from day to day.
One of the attractive features of cryptocurrencies is the inability of the Government to follow transactions so that taxes can be collected. This is especially attractive to drug dealers, money-launderers, and terrorists. Enthusiasts see the increasing use of cryptocurrencies as a money making it a sure bet to rise to astronomical levels vis-à-vis the dollar. They ignore the fact that the U.S. Constitution expressly reserves the power to create money to the Government. It is only a matter of time until the authorities realize that they are missing out on a substantial source of tax revenue and take steps to close that off.
The difference between value and price is a tricky one. Stocks often are selling too cheap or for prices that seem excessive. But compared to what? Answer: Intrinsic value………which is inherent desirability independent of its price. What is the inherent desirability of Bitcoins and the other cryptos except for price? A beautiful day, the smile of a loved one, or the satisfaction of a job well done all have an intrinsic value independent of any price considerations. For cryptocurrencies, the intrinsic value is zero unless you count the intangible value of secretiveness.
As the intrinsic value of any asset class varies from hard to soft, the price it commands (or may be expected to command) is increasingly a function of buyers assuming that there will always be “someone” out there who is willing to pay a little more. When the number of “someone’s” eventually dries up, the bubble always bursts. This is true of all assets. Most speculators believe they will be smart enough to get out before that happens, but that is rarely the way things unfold. To paraphrase Hemingway, bankruptcy always occurs slowly at first, but then suddenly.
A former boss of mine used to say that “A dollar compounded at just 3% per year since the birth of Christ would amount to more money than there is in the world, so someone must have screwed up.”
Ken Veit is a retired actuary and insurance executive.