Crypto's Waiting Game
Critics of cryptocurrencies have often derided the asset class for its high price volatility which, they argue, makes it unsuitable to serve as a medium-of-exchange: one of the three prerequisite functions for money (the other two being store-of-value and unit-of-account). Well, after another month of lacklustre price action the validity of such criticisms are diminishing by the day.
During the whole of September Bitcoin traded within a 10% range, much of it inside an even narrower 5% range1. As a result, realized volatility in Bitcoin drifted back towards historic lows. Implied volatility – a market-based estimate of future volatility derived from options prices – witnessed similar declines. While delta hedging tends to keep the two volatility measures closely linked, anticipation of a future sharp price move can result in divergence (implied rises above realized). The fact that there is no divergence suggests market participants are not anticipating sharp price moves (in either direction2) any time soon.
In my view, this tangible sense of investor apathy provides a fairly strong hint as to where we stand in terms of the overall crypto cycle. Replicated below is a slide I included in a recent video presentation. It shows a stylized Gartner Tech Hype cycle, overlaid with the emotional responses of investors at various stages of the investment sentiment cycle.
Source: Author
Born in optimism and fuelled by a rising wave of positivity bull markets end in euphoria, especially when based on a technological innovation whose full impact is clouded in uncertainty and hence is necessarily highly subjective. At the peak, investor sentiment is so overwhelmingly positive that sound judgement typically goes out the window. In crypto’s case, one of the clearest signs of such rashness was purchasing jpeg monkeys with laser eyes for seven figure sums. Ironically, the time when investors are most confident is also the time when the financial risks are at their greatest.
Once the hype starts to fade, asset prices succumb to economic gravity as inevitably as an apple falls from a tree3 and investors become engulfed in a rising tide of negativity as these risks materialize. The process continues until there is widespread disillusionment and investor sentiment hits rock bottom. A classic tell of investor despondency is low trading volumes and low price volatility - exactly the sort of market dynamics that have been playing out in crypto over the past couple of months.
The End is Nigh
All this may seem downbeat and depressing, but that is the point. I know from my time as a portfolio manager that the most profitable trades are always those that most people disagree with. Why? Because if people agree with the rationale for buying or selling a particular financial asset, then to a greater or lesser extent4 that perspective is already factored into the price. It is why the bottom of the bear market, when investor pessimism is at its highest, is conversely the point of maximum financial opportunity.
We have seen these cycles play out several times during Bitcoin’s 14 year history. The first bear market began in June 2011 and lasted 20 months until February 2013. During this period the price of Bitcoin fell from a peak of $32 to a MT.Gox hack-induced low of $0,01 (ouch!). The next two bear markets lasted somewhat longer, at 37 and 36 months respectively5, and also resulted in fairly substantial drawdowns (in the region of 80% peak-to-trough). The most unusual bear market in Bitcoin occurred in 2021 when the price halved in a six month period, before the rally resumed and it printed it’s all-time high just a few months later. That the global economy was still reeling from the Covid pandemic (not to mention the macro policies it triggered) perhaps explains why this bear market was unusually mild and short-lived.
What about the most recent bear market?
Between the November 2021 peak and last year’s low, Bitcoin fell 77% - a magnitude of decline very much in keeping with previous bear markets. Assuming the latest Bitcoin cycle follows the same profile as earlier cycles, this suggests the bulk of the financial damage from the bear market has already occurred. When one also factors in the low price volatility / trading volumes seen in crypto over recent months, which speaks to the high degree of apathy amongst crypto investors, it seems increasingly clear that we are close to the bottom of the cycle. The question is what could trigger the new bull market?
Searching For A Catalyst
A couple of months ago the green-lighting of a spot Bitcoin ETF seemed the most plausible catalyst to turn things around after BlackRock – the world’s largest asset manager – filed an application with the SEC. However, the US regulator has pushed back the decision timeline on all spot Bitcoin ETF applications after a US court criticized its earlier rejection of Grayscale’s ETF application. So, while I and many others judge the US will eventually allow a spot Bitcoin ETF product - opening crypto up to a wider, more diverse, set of investors - the chances of it happening in the near-term seems remote. Fortunately for the bulls, there is another potential catalyst looming on the horizon, once that is getting increasing coverage in the crypto world.
Halvings
After every 210,000 Bitcoin blocks are mined (approximately four years) the block subsidy paid to Bitcoin miners for solving the SHA-256 hash function is cut in half. It is the mechanism that ensures the total supply of Bitcoin is capped at 21 million. History indicates that “halving events” have quite a marked impact on Bitcoin prices. To illustrate this point, take a look at the following chart which shows the price performance of Bitcoin around the three halving events Bitcoin has experienced. To aid comparison, Bitcoin’s price is indexed to 1 on the day of the halving and the scale is converted into logs. I chose 200 days prior as the look-back window because the next halving event – anticipated to occur on April 25, 2024 – is just over 200 days away.
Bitcoin Halvings – Price Performance
Source: Author calculations
No obvious price trends jump out in the approach to the halving, but afterwards is a very different story. In all three instances Bitcoin’s price rallied substantially. The weakest performance occurred after the last halving when Bitcoin’s price “only” went up 5X!
In light of such an impressive track record crypto players, not surprisingly, attach considerable significance to this quadrennial event. However, explaining quite why Bitcoin’s price gets such a substantial and seemingly consistent boost in the months following halving events is not as straightforward as is often presented.
Stock-To-Flow
The standard explanation for this phenomenon is encapsulated in the much-talked about stock-to-flow (S2F)6 model put forward by the anonymous Plan B back in 20197. The rationale given is that a reduced block subsidy means there is a fall in the number of new Bitcoin’s coming on to the market (flow) relative to the outstanding supply (stock) of Bitcoin and this increased “scarcity” puts upward pressure on the price of Bitcoin.
As an economist I am not overly keen on this model. My first problem arises from the fact that Bitcoin halvings are, to all-intents-and-purposes, fully deterministic. We know from the Bitcoin code at what block height the halvings will occur, and we know by how much the block subsidy will be cut. The only small degree of uncertainty is when the 210,000th block will be mined as block times are not fixed.
Given the future supply is known so far in advance – we can be confident on halving events all the way out to the final one set to take place in 2140 – one would naturally expect rational, forward-looking profit-maximising investors to pre-emptively buy Bitcoin ahead of halving events in anticipation of higher future prices. In doing so, this would pull forward the positive return and smooth out the subsequent price rally. Yet, for some reason this appears not to be the case. Some may counter that assuming investors behave so rationally is flawed because we also witness predictable patterns in tradfi asset prices. However, these “seasonals” as they are labelled are mainly the influence of external factors, such as widely observed holiday periods (summer/December) or due to the periodic nature of tax payments/receipts. None of these are applicable to an event like Bitcoin halvings that occur at a four year frequency.
A more substantive objection to the S2F model, one Plan B readily acknowledges, is that it only deals with the supply side of Bitcoin and as every student of economics knows, price is determined by the interaction of supply AND demand. Just because something is scarce does not automatically convey it with an ability to serve as a store-of-value (one of the other prerequisite functions of money). This means the mechanistic pricing of the S2F model is flawed, but it does not mean it is totally misleading. As long as there is consistent demand for Bitcoin, increased scarcity should translate into higher prices.
And what is the likely source of this consistent demand? As I wrote at the back-end of last year…
“My judgement is that cryptocurrencies will not only survive but thrive because the fiscal challenges facing pretty much all of the major economies in the world are of such a magnitude that it is highly improbable governments will be able to avoid deploying the printing press, resulting in the further erosion of fiat money’s purchasing power.”
Patience Is A (Profitable) Virtue
Sure, the near-term cyclical outlook has become “muddier” given the US economy has held-up better than one would have expected in light of the growth headwinds that materialized last year, and the Fed has maintained a tightening bias all of which has dented demand for crypto. However, absolutely nothing has changed when it comes to the longer-run outlook.
Unless governments grasp the “fiscal nettle” and start to cut spending commitments both now and in the future (dealing with the massive unfunded liabilities as a result of population ageing), worries about the ability of fiat money to continue to serve as a store-of-value will persist. As a result, crypto will remain in demand because of its ability to serve as a fiat hedge, meaning that like the three Bitcoin halvings before the one slated for next April will likely be the perfect catalyst to kickstart the next crypto bull market. (Assuming, of course, a spot Bitcoin ETF doesn’t arrive before then).
Lacklustre markets like crypto today are challenging as no one likes to play the waiting game. However, at such times it is worth bearing in mind the wise words of Berkshire Hathaway’s CEO, Warren Buffet, a man who knows a thing or two about investing.
“The stock market is a device for transferring money from the impatient to the patient.”
The same is true of crypto.
1 As I have pointed in my weekly updates, all the recent price action has been centred on second tier alt-coins – see: https://trakx.io/trakx-weekly-update-september-25/ and https://trakx.io/trakx-weekly-update-september-18/
2BTC option 25 delta skews are close to zero, implying not much preference for calls (buying BTC) over puts (selling BTC) – see: https://www.theblock.co/data/crypto-markets/options/btc-option-skew-delta-25
3I couldn’t resist the veiled reference to Isaac Newton.
4The extent reflects how widely shared those opinions are.
5November 2013 – January 2017 and December 2017 to December 2020.
6See: https://www.lookintobitcoin.com/charts/stock-to-flow-model/
7See: https://medium.com/@100trillionUSD/modeling-bitcoins-value-with-scarcity-91fa0fc03e25
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