Wall Street Blew a Bubble in Stocks, Cryptocurrencies are Next

The ideal bagholder is one who adds more on every downturn (buying the dip) and who refuses to sell (diamond hands), holding on for the inevitable Fed-fueled rally to new highs.

Jeremy Chan knew that the scheme being proposed to him was a Ponzi scheme from the get go.

Sitting in the tropical heat of a coffeeshop in Penang, Malaysia, Chan listened patiently as his childhood friend of almost twenty years waxed lyrical about how he had discovered this “options trading guru” who promised a steady return of around 7% a month.

Chan had heard similar pitches countless times before, after all, Penang was home of the so-called “money game” — pyramid schemes typically based on some investment, that eventually collapsed under their own weight when new investment monies ran dry.

Having successfully participated in numerous such schemes, the only thing Chan wanted to know was when this latest one had started — because ultimately that was all that mattered.

Like so many other investors who are familiar with “money games,” the key to rolling the dice with any Ponzi scheme is making sure you got out before everyone else.

Often times, if old hands are hearing about a money game after the first set of investors have already been paid off, they’ll sit that round out, but fresh schemes were always of interest.

As Chan’s friend droned on, he realized that this latest scheme that was being described to him was only in its startup stage — the best time to get in.

Paying for their coffees, Chan got up to leave the coffeeshop having promised to invest the princely sum of 500,000 ringgit, or about US$118,500.

Because ultimately Chan wasn’t concerned the “investment product” was nothing more than a Ponzi scheme, he cared only that he was in and out before everyone else.

Blowing Bubbles

Which is why the recent rally in equities should provide plenty of clues as to where Wall Street is headed to next.

Unlike other parts of the world, where retail investors form the bulk of investment flows in stock markets, on Wall Street, it’s institutional investors who hold court.

And despite signs that equity valuations are so extreme that the dotcom bubble of 2000 looks mild in comparison, there are few signs of fatigue in the markets.

Seasoned (as opposed to diamond) hands on Wall Street are understandably wary of being overtly bearish and it’s not because of the U.S. Federal Reserve, it’s because after thirteen years, retail investors are finally all-in on investing.

According to data from Vanda Research, at its height, retail investors made up 25% of all trading volume this year, sliding to 20% in recent times thanks to pandemic restrictions being lifted, but remaining persistently high.

Despite eye-watering valuations, there appears to be no shortage of analysts pitching the “this time is different” story — that unprecedented fiscal and monetary policy measures are pushing up asset prices because hot money is running out of options.

As seductively simple as such logic may appear, the reality is far more nuanced — retail investor sentiment, margin debt and the Buffett Indicator all point to an investment environment that is completely detached from objective reality.

Add to that heady mix the gamification of investment, with retail investors gaining easy access to sophisticated instruments like options, through slick, zero-fee trading apps such as Robinhood.

Against this backdrop, negative real yields on safe bonds are being swapped out for equities, not just by pension plans which are buckling under decades of low returns amidst rising obligations, but by individual retirement portfolios as well.

Not My Bubble

The past eighteen months have seen more retail investors go all-in with stocks, supremely confident that they can’t lose, than at any point in the past.

While some of that investing behavior can be attributed to stimulus checks falling into bank accounts like manna from heaven, by now, most of that money would either have been spent or rolled over in the markets.

Self-professed “investment gurus” pedaling their own brand of stock market sorcery on YouTube and TikTok are all signs of what former U.S. Federal Reserve Chairman termed “irrational exuberance.”

If an “investment guru” can explain the market in a 30-second video, it’s not that markets are simple, it’s that their understanding is.

Moral Hazard This

The real driver behind retail investors betting the farm on the market is the complete collapse of the balance between risk and moral hazard.

Prior to the 2008 Financial Crisis, there was at least the appearance the U.S. Federal Reserve was concerned about moral hazard created by intervening in the markets and propping up failing companies or banks.

The very fundamental tenet of capitalism should be that the weak should be allowed to fall, or at least it used to be.

Yet that cornerstone of a capitalist system, that the chips should lay where they fall, has all but been abandoned and replaced with the secular faith that the world’s foremost central bank will never let the markets go down.

Borne from 13 years of relentless central bank intervention and stimulus, all in the alleged service of elevating markets, retail investors are understandably single-minded in believing that asset prices can only travel in one direction.

Since all recent evidence is self-fulfilling, that the markets never go down because the Fed will never let them go down, the trick (at least according to the retail investor mantra), is to rotate into the next winning sector or asset — buy the dip.

Whether it’s a meme stock or cryptocurrencies, Wall Street will provide the justification for why the usual rules don’t apply to that particular asset.

Ready Player One

Before the cryptocurrency investment theater begins, all of the necessary actors need to take their place, chief among which are the regulators — because Wall Street can’t game the system if the rules are ambiguous.

Which is where the Chairman of the U.S. Securities and Exchange Commission, Gary Gensler comes in.

While Gensler is no stranger to cryptocurrencies, having taught the subject along with blockchain technology at the venerable Sloan School of Management at the Massachusetts Institute of Technology, he’s of late expressed concerns that investors require more protection when it comes to the nascent asset class.

Speaking at the Aspen Security Forum last week, Gensler noted that cryptocurrencies were “highly speculative stores of value”, putting the onus on regulators to protect investors.

Gensler noted,

“There’s a great deal of hype and spin about how crypto assets work. In many cases, investors aren’t able to get rigorous, balanced and complete information .”

“If we don’t address these issues, I worry a lot of people will be hurt.”

Gensler vowed that the SEC would act under its existing authority to regulate “crypto assets” that can be defined as securities under U.S. law and his use of the term “crypto assets” should be seen as deliberate.

For the uninitiated, issues of jurisdiction often run rife between U.S. enforcement agencies.

Labeling cryptocurrencies as “currencies” or “commodities” as opposed to “assets” which can be interpreted as securities, provides the SEC with the necessary jurisdictional cover to go in and regulate the space, something which Gensler has already demonstrated the appetite for.

According to Gensler,

“It doesn’t matter whether it’s a stock token, a stable value token backed by securities or any other virtual product that provides synthetic exposure to underlying securities.”

“These products are subject to the securities laws and must work within our securities regime.”

But Gensler has no intention of stopping there, calling on Congress to provide the SEC with the additional powers to protect investors in cases where the rules regarding a constantly evolving asset class are ambiguous.

Against this backdrop, Congress is mulling taxes on cryptocurrency trading, as part of a US$550 billion bipartisan infrastructure package, as all of the pieces are moved into place for Wall Street to cash in on crypto.

As it is, Wall Street is already offering cryptocurrency investments to its most well-heeled clients.

All that’s left is for the SEC to approve a Bitcoin ETF and it’s off to the races as retail investors get pulled in wholeheartedly.

While the initial charge in cryptocurrencies was a grassroots movement led by individuals, there are many retail investors who remain skeptical about the asset class, and who have preferred to sit on the sidelines.

That is until the rules are laid down and retail investors are offered access to the crypto asset class by way of their local bank branch.

In this landscape, and as articulated by Gensler, the role of the SEC is not to adjudge the validity of their investment hypothesis, but merely prevent fraud,

“If somebody wants to speculate, that’s their choice, but we have a role as a nation to protect those investors against fraud.”

With the rules in place, Wall Street can then start to proselytize on the infinite and transformative value of cryptocurrencies.

In this secular religion, nothing else matters and all the old ways are a distraction — forget about valuation and that most cryptocurrencies are merely unconstrained assets fueled by narrative.

Things like cashflow, yield and technical analysis are superfluous in this landscape, just buy the dip and rotate into what’s the next hottest cryptocurrency and watch the millions pile up on their own.

This Time is Really Different Right?

Every generation that experiences a speculative mania feels that it’s singularly unique, whether it was Baby Boomers during the dotcom boom, or Gen X during the subprime mortgage rally.

The confluence of forces driving each epoch’s liquidity-driven asset mania to unprecedented heights is so “obviously” singular and powerful that it would be foolish not to grab a board and ride the wave to riches.

But what freshly-minted cryptocurrency “millionaires” holding on to their private keys don’t realize is that they’re the marks and the bagholders.

Wall Street has been patiently waiting for this moment, when a new, disruptive and difficult to understand technology promises to revolutionize the world and sell the crap out of it.

Even better when this nascent asset class can’t be valued using traditional metrics.

Whereas dotcom stocks were still susceptible to being analyzed according to measures like price-to-earnings ratios, cryptocurrencies aren’t constrained by such limitations, making them the ideal product to be sold to the most unsophisticated and unsuspecting investor.

Which is why high net worth individuals and institutional investors are beefing up their cryptocurrency portfolios — now is the time for accumulation so Wall Street and its best clients can wait for retail to go all-in.

And so the pros can sell all the over-valued cryptocurrencies to the euphoric, trusting retail traders, who will continue to buy the dip and rotate into the next hot digital token until their fortunes have dwindled to spare change.

The ideal bagholder is one who adds more on every downturn (buy the dip) and who refuses to sell (diamond hands) — that’s how the rich take from the poor.

But Wall Street is patient, and a new crop of bagholders eventually ushers in the transfer of over-valued assets to a new generation of bagholders.

It doesn’t matter that ultimately it may be a con — the key to profiting from the con is knowing when to get out and failing which, know when to ask for a bailout — Wall Street has mastered both moves flawlessly.