The Bitcoin “Penny Stock”

For almost a decade, Bitcoin has periodically captured the attention of the public. Sometimes for its technological potential, sometimes as an object of ridicule, but often times for its boom / bust cycles that have fueled the limitless imaginations of speculators.

Since the start of this year, Bitcoin and alt-coins have once again captured the attention of the public.

Not only has Bitcoin risen dramatically in price, potentially minting hundreds of millionaires and possibly a few discrete billionaires, the blockchain, alt-coins, and ICOs appear to be carrying us at light-speed into a radically democratized and de-centralized future.

I’m not here to speak to the technological appeal of blockchains — for which there are many — as there are many more qualified minds that can do that better than I can.

However, I do have news for you:

Bitcoin’s meteoric rise in price year-to-date has more to do with the technicals and conditions normally found in penny stocks than likely any long-term fundamental factors. 

Before you immediately dismiss the rest of this post because you suspect my argument is for lower prices, I will be upfront and tell you that that is not the case. I have no particular view on whether cryptocurrencies will go up or down. My goal is simply to discuss what I believe has been the primary driver of upward momentum and leave it for the reader to assess whether these conditions will continue favorably or potentially reverse. Having observed the rise of many penny stocks, I have seen few that don’t eventually come crashing back down in dramatic fashion when the conditions that made the rise possible cease to persist.

The Anatomy of a Penny Stock Shooting Star

Most penny stocks never amount to anything. But occasionally, a few rise and rise and rise in dramatic fashion. Sometimes up to thousands of percents within a few days or months.

For example:

Every penny stock shooting star begins with a similar set of conditions: Limited information, micro market capitalizations, and extremely low liquidity.

All of these factors come together to maximize the chance that a / any penny stock can be easily manipulated to trade on everything but fundamentals.

Fundamentals are usually the enemy of penny stocks since most of these have no long-term successful business models. What they might have are seductive stories – potential to change the world, potential to transform society, and the most seductive story of all, the potential to make you very rich very quickly. Limited information creates the right environment to nurture these stories because whatever information you can get becomes definitive. The siren song these stocks sing are already powerful in and of itself, but even more so when there are no other credible voices of caution.

Micro market capitalizations further nurture this environment because it usually keeps professionals away. By virtue of having a small market cap, it is nearly impossible to make meaningful amounts of money for the professionals (e.g. shorting), and thus many that could see through the risks of penny stocks are not engaged. Retail investors also popularly assume that many long-term winner once began as penny stocks:

Investors who have fallen into the trap of the first fallacy believe Wal-Mart, Microsoft and many other large companies were once penny stocks that have appreciated to high dollar values. Many investors make this mistake because they are looking at the “adjusted stock price,” which takes into account all stock splits. By taking a look at both Microsoft and Wal-Mart, you can see that the respective prices on their first days of trading were $21 and $16.50, even though the prices adjusted for splits was about eight cents and one cent, respectively. Rather than starting at a low market price, these companies actually started high, continually rising until they needed to be split.

-Investopedia, The Lowdown on Penny Stocks

But the most important one of all – low liquidity. It is through low liquidity that penny stocks gain their immense volatility. As money pours in (or out), low liquidity guarantees that trades will easily move penny stocks like a leaf-blower through a forest floor.

Why Some Penny Stocks Soar While Others Languish and are Simply Forgotten

Many retail investors have limited ability (or perhaps desire) to conduct research on companies. Many retail investors are simply chartists. But to become a shooting star, penny stocks need a story. Although the most seductive story of all is always the same – you can be rich very quickly – even speculators usually demand a story that has some semblance of fundamental long-term potential.

Because of that, many penny stock shooting stars begin with a sponsor that formulates this story and sells it to potential speculators. These sponsors are the ones that get the flywheel going. Story formulation is not the hard part, but how do you convince speculators that there is potentially a lot of money to be made? The easiest way is to show that a lot of money has already been created, but don’t just sit there or you will miss out on all the rest! By targeting low liquidity penny stocks, a sponsor can buy a meaningful amount of stock initially, which drives up the price because of the low liquidity. This creates the initial gains that will eventually draw in other speculators. Once the flywheel is in full motion, the sponsor will quietly sell down the initial purchase at a handsome gain, leaving speculative followers with the aftermath.

This is known as pump-and-dump:

The same scheme can be perpetrated by anyone with access to an online trading account and the ability to convince other investors to buy a stock that is supposedly ready to take off. The schemer can get the action going by buying heavily into a stock that trades on low volume, which usually pumps up the price. The price action induces other investors to buy heavily, pumping the share price even higher. At any point when the schemer feels the buying pressure is ready to fall off, he can dump his shares for a big profit.

-Investopedia, Pump and Dump

Regardless of how sophisticated you are with the markets, I’m quite certain most people know that pump-and-dumps never end well (unless you are the sponsor or a speculator that recognizes a pump-and-dump for what it is and are able to get out in time).

Drawing Parallels to Bitcoin

So what are the parallels to Bitcoin and alt-coins? Simple, all the conditions that make penny stocks potential vehicles for speculation have been present in Bitcoin and alt-coins.

Firstly, Bitcoins and alt-coins are new areas driven by technology that has not matured and continues to evolve. This creates an environment that is a vacuum for information that is necessary to judge the long-term fundamentals of the asset class. In addition, the amount of technical knowledge needed to understand cryptocurrencies mean that a small subset of people can establish themselves as the de-facto experts on the future and possibilities of cryptocurrencies. Regardless of whether these expert opinions are well-placed or not, they formulate and control the story and overwhelmingly the story has been about the potential for cryptocurrencies to change everything – your life, your finances, government, everything.

Cryptocurrencies in the aggregate recently accumulated a market cap of >$160bn, certainly not micro cap under any definition. However, we should view that in light of the 30-40x growth within the past year. We need to consider the market cap before the rise, and even as recently as October of last year, the aggregate market cap of all cryptocurrencies according to Coinmarketcap.com was as low as $13bn.

And as with penny stocks, the most important factor of all – low liquidity. I cannot overstate how important this factor is for understanding why Bitcoin and cryptocurrencies began a sudden rise less than a year ago.

Let’s take a look at Bitcoin trading volumes over the last 6 months (via data.bitcoinity.org):

We can observe a few spikes here and there, but overall the volumes have been fairly steady. Do note that volumes rose significantly as the recent sell-off intensified in August / September.

But the more informative chart is to see what volumes have done over the past year – you will be shocked:

Volumes absolutely collapsed between December and January. In fact, liquidity nearly entirely dried up.

Where did the liquidity declines come from? Cutting the data another way, we can see which exchanges were responsible for most of the trading over the past two years: BTCChina, Huobi, and OKCoin. These three exchanges were responsible for close to 90% of all Bitcoin trading over the past 2 years, but suddenly the entire volumes of all three exchanges evaporated at the end of last year.

The drop in volumes was due largely to Chinese regulations tightening up the trading of cryptocurrencies. Coindesk featured an interesting article highlighting this dynamic earlier in the year.

Due to the significant decline of Bitcoin trading volume earlier this year, I believe it is clear that Bitcoin’s low liquidity created conditions that are normally only observable in penny stocks. This low liquidity likely allowed well-meaning technologists and venture capitals that are true believers of cryptocurrencies to inadvertently act like sponsors akin to those of penny stock schemes. The buying of cryptocurrencies into extremely thin liquidity created the initial 5x-10x gains that would later bring masses of retail speculators.

Do All Shooting Stars Eventually Burn Out?

Here’s the thing – with penny stocks, the rise usually comes to an end because the sponsor sells out at the top. The sponsor considers when s/he has maximized the number of speculators (or prey depending on how you look at it) that can get pulled in and then will sell out at the top. Sponsors always have an endgame of getting out before the crowd finds out.

I have no doubts that given the extremely low liquidity in cryptocurrencies today, that if the large cryptocurrency wallets (and yes, there are a number of wallets out there are are very massive in size) were to cash out, downside volatility would be as dramatic as the rise we have seen year to date.

The question is how many of the early “investors” in cryptocurrencies believe enough in the long term to not be concerned about volatility and therefore feel compelled to go back into cash / government-issued currency? If Bitcoins and alt-coins were truly only in the hands of true believers, low liquidity could mean that we continue to see these cryptocurrencies appreciate 50x or 100x or even more from here.

The question is, again, are cryptocurrencies in the hands of true believers?

One anchor that many investors / speculators in Bitcoin fixate on is that the number of Bitcoins that will ever be in existence is fixed (currently growing at a small rate but total that will ever be mined is fixed). Yes – this is true, and perhaps one reason why Bitcoin should appreciate relative to the growing stock of government-issued currency. But 30-40x in 9 months? That’s only possible not because the stock of Bitcoins is fixed, but because the tradable float of Bitcoin has been declining. Just ask yourself how many cryptocurrency investors you’ve heard say that they will buy and sit on it and never sell – these coins are locked away and in effect reduce the tradable float. The tradable float is declining every day.

When will this locked up float suddenly come back to exchanges? That will be a terrible moment.

As I mentioned at the beginning, I’ll leave it up to readers to decide on the direction of prices. I have no view. What I have a view on is that Bitcoin and alt-coins have increasingly become like penny stocks.

I’ll close with a quote from Fred Wilson, a celebrated Venture Capitalist:

I know a lot of people who are true believers in crypto and have made fortunes in it. They are “all in” on crypto and have much of their net worth (all in some cases) invested in this sector. I worry about them and this post is aimed at them and others like them. It is fine to be a true believer and being all in on crypto has made them a lot of money. But preservation of capital is about diversification and I think and hope that they will take some money off the table, pay the taxes, and invest it elsewhere.

-Fred Wilson, Diversification (aka How to Survive a Crash)

Beware – even the faith of the true believers may waiver.