There is a lot of excitement and confusion around cryptocurrencies. As long as people treat their gambling as such, then little harm will result, but as soon as folk start counting eggs as chickens, then that is where the market cap fallacy kicks in, and we started to see this in 2018.
The market cap is not the total value of an asset – it is nothing more than the last price paid. it might sound a strange thing to say, but it is the number one misconception people have about investments.
This example should help show why.
- Create 10 tokens
- The price of the token is set by supply and demand.
- Initially there is just one person asking for a token and I have 10. I sell it to her for £1
- Then another couple of people come along wanting tokens, and I only now have 9, so I sell them both one for £1.50 each.
- At this point I have sold 3 tokens for a total of £4 as well as 7 unsold tokens.
- Another two people come along, but since I only have 7 left, I can double the price to £3 each. Having seen the price rise already, they seem happy to pay it.
- People notice the steady rise in price £1 -£1.50 – £3 and suddenly now 4 people come in asking for tokens and I only have 5 left. Even though I put the price up to £10 I still sell 4!
- To summarise. I have sold a total of 9 tokens, getting £50 in return and I still have one token left.
- After seeing the price x10, suddenly 100 people want to buy my last token, and I keep upping the price until there is only one person left prepared to pay £100 for that last token.
- I’ve sold all my tokens and I got £150 in return.
Everyone is very happy. The market cap of these tokens is £1000! But only £150 was paid in. Somehow, magically, that money was multiplied seven fold. Of course it wasn’t, and if people start selling, the same logic works in reverse to reduce the price.
This is what lies behind an inflationary asset bubble.
If the first 5 investors now choose to sell, then the “market” won’t pay £500 if the demand is not there (remember we only had one person desperate enough to pay £100). The price now lowers to what it can afford – say £10 a token, or £50. This is still a profit for the earliest investors, and stop-loss trading automation kicks in and sells even for the next 4 investors. Now with 9 tokens available, the price falls even further to say £1.
The last person in who paid £100 for a token now worth £1 cries “where did all the money go?”
It was never there.
Note this is true of every asset including stocks and houses. When we have large numbers of people treating the unrealised value of their asset as effective cash (e.g. using stocks or houses as loan collateral), we have an inflationary bubble that can only go so far before it pops in a sticky mess. See 2008 for further details.
And it gets worse. There is no guarantee, especially in a falling market, that anyone will want to buy what you are selling. It really doesn’t matter what you think the price is worth today, if you believe it will be less tomorrow. This is why typically you see liquidity dry up quicker sometimes than the price falls. The housing market is a great great example of this. A more topical example is when your ICO trading platform starts becoming “unavailable due to excessive demand”.
Paper or digital millionaires aren’t. The price to acquire is not the price to liquidate. Those two values can be, and usually are, radically different. It’s a fundamental error many people, including even standard accounting statements make. There is no “mark to market”.
I knew someone in the US in 2002 who lost their home using their employee stock as the loan collateral (also avoiding taxes on the capital gain), which subsequently tanked, so consider this a cautionary tale. Stocks, houses, bitcoins, alt-coins are not money until you actually sell them.
The confusion arises because market cap represents just two people’s view on what an asset is worth (the last persons to buy and sell to each other), not what the entire asset could be sold for (what an average of multiple people would pay). It’s a misnomer as there is no “market” in “market cap”.
One important side effect of this is that you cannot compare market caps since liquidity can be so very different.
An an example of this is the ridiculous comparison that Bitcoin’s market cap exceeded PepsiCo –
Perhaps an even clearer example from the recent past was Japan’s bubble economy when at one point, the implied land value of the Imperial Palace in central Tokyo was apparently worth more than the entire land value of California. But it wasn’t – clearly if you could actually buy all of California, then it would be worth more than the Japanese Imperial Palace. The problem is that you cannot extrapolate the total value from prices of individual office blocks in Tokyo and California.
Price is set by supply and demand, and this is dependent on volumes – how many are selling, how many are buying. That in turn is driven by genuine value – the gravity which ultimately controls price.