Here's How a Bitcoin Crash Could Bring Down the Entire Stock Market

Conventional wisdom says that even if the Bitcoin bubble pops, as it's been threatening to lately, the damage won't spill over into the broad stock market.

That's because in dollar terms, the cryptocurrency craze remains tiny compared to, say, the dotcom boom, which led the broader market to a painful crash in 2000.

Internet stocks in the late 1990s represented a substantial portion of what was then (and is again) the largest sector of the economy: tech. By comparison, the sum total value of all Bitcoins and other cryptocurrencies circulating in the world now is smaller than the current market capitalization of just one company: Microsoft.

"For a potentially destructive bubble to form, cryptocurrencies need to be far more adopted and become a much larger share of household assets or the assets of leveraged investors like banks or some hedge funds," says Jeffrey Kleintop, chief global investment strategist at Charles Schwab.

Still, there are three plausible ways the bursting of the Bitcoin bubble could gore the aging bull market in stocks, which is about to turn 9 years old in March.

Scenario #1: The Bitcoin bubble bursts investor confidence.

"The real thing that Bitcoin's rise represents is the growing sense of confidence in this recovery," says Jim Paulsen, chief investment strategist at The Leuthold Group, an asset management firm based in Minneapolis.

Paulsen points out that Bitcoin prices didn't really start to rise dramatically until the end of the third quarter of 2017, when it became clear that the economy was accelerating.

In that sense, Bitcoin has a tangible connection to stocks. The same investor confidence that's been fueling risk-taking and speculation in the global equity markets has also been behind the cryptocurrency rise that accelerated in the fourth quarter of last year.

So while a collapse in cryptocurrency prices won't necessarily have an economic impact on equities the way the Internet bubble did, it could have a domino effect on investor psychology.

"If there's a collapse in Bitcoin, the direct financial impact won't be overwhelming, but it could set off a lot of fear and very radically alter people's mindset—which in turn could be damaging for stocks," Paulsen says.

And if cryptocurrencies "really crashed and burned, that could really shake people and be enough to create a real market impact," he adds.

Scenario #2: Companies jump on the Bitcoin bandwagon just before a crash.

In the late 1990s, investors started noticing something: All a company would have to do was to put a dotcom at the end of its name or include a sentence in a press release about launching an e-commerce site, and the stock would jump.

Well, something similar is happening with cryptocurrencies today, and that's pulling more and more companies into this frenzy—making its impact on the economy much larger than the market value of cryptocurrencies would suggest.

The imaging company Eastman Kodak recently hitched its struggling wagon to cryptocurrencies—initially by launching its own virtual currency, KodakCoin, which can be used by photographers to securely sell the rights to their photo and receive payments using blockchain technology.

That move sent Kodak stock, which lost 80% of its value in 2017, soaring. Since the announcement, on Jan. 9, Kodak shares have more than tripled in value.

Kodak then doubled down on crypto. According to news reports out of the CES consumer technology show, Kodak plans to partner with a company that will lease Kodak KashMiner computers to mine for Bitcoin.

And Kodak is hardly alone. In recent months, KFC Canada introduced a special "Bitcoin Bucket"—which includes 10 chicken tenders, fries, a medium side dish, gravy, and dips—that can only be purchased using the virtual currency.

And after restaurant operator Chanticleer, which operates a number of Hooters franchises, announced at the start of the year that it was launching a rewards program using cryptocurrencies, its stock—which had sunk 96% between the start of 2012 and the end of 2017—rebounded 20%.

Some companies aren't just dabbling in cryptos. They are changing their entire business models.

Late last year, the biotech equipment maker Bioptix changed its name to Riot Blockchain and its business plan to investing in cryptocurrencies and blockchain technology. Within weeks, the stock soared 650%.

The same thing happened with Long Island Iced Tea, a little-known beverage maker that changed its name to Long Blockchain and its business model to investing in blockchain technology. The stock soared more than 200% shortly after the news.

It all sounds promising. But as many market watchers point out, Pets.com and Webvan.com were considered winning bets in the late 1990s—until the bubble burst and the fog lifted.

Scenario #3: A cryptocurrency crash has a Wile E. Coyote effect.

Jack Ablin, chief investment officer at BMO Private Bank in Chicago, recently told Money that stocks sometimes "act like a cartoon character who's run off a cliff. Once they realize there's nothing support them, they start to drop."

In other words, investors are often willing to keep going in one direction, even if it seems risky or irrational, until they're jarred. But when they are scared or shaken enough—for instance, by a financial collapse, like in the global financial panic in 2007—they start looking down at their feet and notice how dangerous their strategy really is.

Is a crash in Bitcoin a big enough to get investors' attention?

It's too soon to tell, but as Paulsen points out: "You can't hardly go anywhere in the financial world or financial press without seeing a mention of Bitcoin."