Recently, one of my friends asked me if it was right to invest in the Bitcoin? My answer immediately was "I do not support it !" Then an interesting question intrigued my mind, Where is
the world of investments heading? Is it moving away from reality? I write down through this article a series of thoughts that lead to this question.
The History of Money
The history of finance dates back to the times when humans transacted through a barter system. They exchanged goods which they actually used and valued. Hence, if a person was in a real need of food i.e., the utility derived from getting 1 kilo of wheat was very high, then they would want to sacrifice more of their own goods. Exchange evolved and gold and other metals were accepted as a medium of exchange across different parts of the world. Metals have their own value also known as the intrinsic value owing to its "physical" form and limited supply.
Eventually, in the 11th Century China, paper money was introduced, but the world faced a problem with such a medium of exchange. Paper money was very easy to make virtually unlimited in supply or in other words, does not have any intrinsic value. To solve this problem, the paper currency was considered as a guarantee by the bank that is liable to pay an equivalent value in gold (or any other metal prevalent in the country) to the bearer of the note. This was also known as a banknote. This gives some extrinsic value to the currency notes. Eventually, the currency was regulated and central banks were set up for countries. These banks were expected to maintain gold reserves proportional to the notes issued. In conclusion, the notes were a proxy of gold which was actually difficult and heavy to transact with.
The US entered into a Bretton Woods Agreement with the rest of the world, which stated that the currency of member countries was pegged to the value of the dollar and the dollar's value was fixed with the value of gold in the federal reserves.
The notes were always marked with a promissory note from the governor of the bank saying
"Will pay to the bearer on demand".
For example, back then if you went to the federal bank with a $20 bill, the bank would be liable to give you gold worth $20. This was true only till 1971.
What happened after 1971?
The then US President Richard Nixon disagreed to provide with any more gold reserves in order to issue more US Dollars. Which meant, either the government had to stop printing notes or print notes without any credible backing from commodities, and guess which option did the US choose? This introduced fiat currency. It is the type of currency which is not backed by any commodity but is just a guarantee provided by the government that the currency in use is a "legal tender" and can be used to repay debt.
Instead of gold, today the governments issue treasury bills to the banks in return of currency notes.
In other words, if today you go to the bank with a Rs 1000 note, you will get a treasury bill of equivalent worth which in turn you have to take to the government of India on maturity. At this point, the government will give you back your Rs 1000 in currency notes itself.
Isn't this hilarious?
This ended the Bretton Woods system and the currency was dealt as a Free Float.
Which means the value of a currency is dependent only on the demand and supply of it.
This was the first evidence when economy shifted from reality.
Fast Forward to modern times
Let me come back to the topic that I was discussing in the first paragraph. Why don't I support bitcoin? Bitcoin is a cryptocurrency invented by a group of "unknown" individuals, is a completely decentralised system meaning no regulation from the banks or Government.
Isn't this hilarious again?
Now bitcoin is based on blockchain technology and is gained as a reward for a process called mining which I and the majority of the bitcoin holders completely fail to understand is trading at whooping $40,700 USD, 1,38,471% (1.38 Lakh %) up from its value in 2012. Most reports suggest that this is not the end of its raise and that Bitcoin is the future of currencies.
Let me get this straight, bitcoin is a piece of virtual money having no physical value (except for the electricity cost and the machines used to mine it), not regulated by any government, invented by unknowns but still one of the most sought after currency.
Do you still want to invest in Bitcoin?
The answer could still be yes! Why? Well if a person in future is ready to give me $1Lakh for 1 Bitcoin why wouldn't I buy one now? That is the only reason one can buy Bitcoin today. If the system were to crash or liquidate or invalidated through regulation, there is no way you are getting dollars in return of the Bitcoins.
Well this isn't true only for Currencies
Stock Markets today are showing similar unprecedented growths in its valuation. Even when the economy is stricken with a health crisis and businesses aren't booming as much, The Nifty, Dow and other markets are at an all-time high. Companies are valued so high based on how they are expected to grow in future. The good thing here as compared to currencies is that some part of the valuations of stocks is real. As in, has physical value in terms of assets of the company.
Finquity+ has already made a video on the same and is embedded. This video shows why have we seen such growth. (Do follow us if you haven't)
Let's look at what an appropriately valued market looks like:
In the year 2003, the Nifty 50 index was valued by the market at 925 points
while its P/E was 13.44
The rally of Nifty in the coming years took it to 6,100 points ( a 560% increase) in the end 2007 P/E still being at around 25 (in its normal historical range of 15-30). In other words, the rise in Nifty was backed by an appropriate rise in the earnings of the companies. Today, the nifty rose by around 200% from its March lows with a very high PE of 39.5 (way beyond its normal range) is not at all backed by an equivalent growth in earnings.
The following heatmap will give you a better picture:
This is hilarious one more time!
But let's face it, If I think that a person would be ready to pay me Rs 3000 in near future for a share of Reliance, I would surely want to buy it today for Rs 1900.
Startups are no different
Similarly, with startups, startups today are valued so much only because they have a large and evergrowing user base which probably uses the service for free or at a very unsustainable rate, or because a big shot like Alibaba or Softbank has planned to invest in them. What Venture Capitalists look for is a very high exit value for their share by the way of an IPO. Most of the startups burn a lot of cash and have a no concrete plan for profitability (for eg WeWork) which eventually crash. The ones suffering are always retail investors.
You can get a better view of the startup environment through a research paper me any friend Kashish Solanki (a classmate) wrote and is attached here. Click here!
In short,
Currencies have no commodity backing but are used everywhere.
Cryptocurrencies neither have a commodity nor a regulatory backing even then in high demand
Listed Companies may have physical assets but still are highly overvalued.
Lastly, Startups have a weak revenue and profitability model still attract heavy investments.
All these points make me question:
Is the world of finance moving away from reality?
Stay tuned for more such intriguing thoughts on finance, #GoSlowBeConsistent
Jay Vankawala
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