Sound Money

The recent gold all-time highs supports the store of value theme, which further increases my confidence for bitcoin’s price prospects over the coming quarters. Technical analysis suggests that the price rise above $10,000 is an important development for bitcoin, but the price remains well below all-time highs, which would be the final confirmation of the bull-market. Despite these supportive developments, broader interest in bitcoin (according to Google Trends data) is contained relative to history, which suggests that the accumulation phase remains intact. MicroStrategy’s bitcoin purchase, Emerging Market attention and growing traditional financial market participation are three potential triggers for the next phase. I advise readers to front load decision-making efforts before the speculative phase gets underway because it will likely be wild and disorientating. Important to reiterate that this report is for informational purposes. It doesn’t detail the economic, social and ethical imperative for the trend towards bitcoin, nor does it serve as investment advice.

Highlights

1. Rediscovering store of value
2. Accumulation phase intact
3. Dangerous to delay until speculative phase
4. EMs could signal next phase of bull-market
5. Commercial traders increase open interest 400%
6. MicroStrategy confirms financialisation trend
7. Technical analysis supportive
8. Price ranges (not forecasts)

Rediscovering Store of Value

In my eyes the rally in the gold price to all-time highs (ATH) confirms that financial markets are rediscovering store of value. Overvalued traditional asset classes, low interest rates and central bank currency devaluation generate renewed appreciation of assets with constrained supply and limited growth/productive premium. I’ve written about the gold bull-market so I won’t repeat those Store of Value arguments here. Suffice to say that I remain bullish and I think the gold ATH is an important development for bitcoin.

Bitcoin doesn’t have the history of gold, nor the institutional memory and (apart from its existing users) it isn’t as culturally entrenched. But it has a more conservative supply schedule. Gold’s supply grows between 2% and 2.5% each year, which is very low relative to national currencies, but new discoveries are still possible, which can boost supply growth. As the gold price rises, this incentivises gold miners to conduct riskier prospecting, bring new mines online and boost gold supplies. Additionally, a higher price encourages new scientific techniques to extract gold from waste substances, which weren’t profitable at lower prices. I.E. gold supply can increase, even though its very unlikely to grow much more than 2.5% per annum. At the extreme, large deposits could be found on asteroids. Here’s a humorous video of the Winklevoss twins making this point to Davy Day Trader Global (The cheerleader of retail trading in 2020): https://t.co/w4a4Mjs0Cy

Obviously asteroid mining is very unlikely, and it would cost time and money to get to that point, but it’s a risk. Not a big enough risk for me to dislike gold, but there are risks with all investments and one needs to be aware of them.

Bitcoin’s supply is hard coded into the protocol. Supply won’t exceed 21 million bitcoins, ever. As computing technology increases, bitcoin’s difficulty adjustment quickly reduces the reward earnt by bitcoin miners. This ensures that a new block will only be mined every 10 minutes on average and that the growth in bitcoin supply asymptotically approaches 21 million. Currently bitcoin’s y/y supply growth is less than 4%, which is higher than gold’s. But the block reward (new bitcoin supply received by miners) halves every 4 years, which implies supply growth drops dramatically over time. This dynamic is clearly visible in the graph. In 2040, bitcoin’s supply growth will reach 0%, making it a unique commodity. The only other assets with 0% supply growth are collectables, like paintings and base-ball cards that are valuable but poor forms of money because they aren’t divisible, durable and distributable. Bitcoin comes with its own set of risks, but its supply growth will be lower than gold’s in the future.

While these gold and bitcoin will compete with each other over time, the bull-market in store of value will lift both boats simultaneously (potentially indiscriminately). It already is, but I expect this will continue. I provided a broad price valuation perspective in the previous bitcoin report, which could see prices hit anywhere between $30,000 and $250,000 during this cycle, so I won’t repeat that analysis again here.  And no, I am not concerned by the massive price ranges!

Why? First, stores of value like gold and bitcoin are priced in US dollars. The value of the USD could change considerably over the coming years as the Treasury tries to keep the economy going through stimulus checks and the Fed monetises debts. Variations in USD valuation make price targets of assets denominated in USD highly variable. Second, stores of value are competing with traditional asset classes for a share of global capital. The trajectory of global equity, bonds and property are variable. This variability in bitcoin price expectation is the reason why I’m placing emphasis on the indicators in this report. They provide an indication of market exhaustion that are not necessarily price dependent. Exhaustion could emerge at $25,000, it could emerge at $50,000, or any other price, depending on the prevailing market conditions.

Accumulation phase intact

Interest in bitcoin is ticking higher, according to google searches, but remains contained relative to history.  I break this normalised trend data into 3 phases; low-moderate interest in bitcoin, elevated and peak optimism. The characteristic differences are in terms of the subsequent returns from each period, which I’ve shown in the table below (average subsequent 1-year returns, compounded 1-year returns, the bottom decile of monthly 1-year returns and the minimum 1-year subsequent return [all monthly data]). Historical data doesn’t predict future returns but its useful to characterise cycles and create expectation ranges. Observations:

1. The minimum 1-year subsequent return observation is deeply negative during all periods. I.E. bitcoin is incredibly volatile no matter the conditions. Don’t invest if you cannot stomach 50%-75% drawdowns.
2. The low and moderate interest phases are similar which is why I bucket them. During these phases the subsequent 1-year returns have been strong but downside volatility is still expected. These periods are the norm in bitcoin with 80 monthly observations since 2012.
3. The only difference between low and moderate phases is at very low levels of interest in bitcoin, the bottom decile of returns become positive.  I.E. if one buys bitcoin when there is very little interest, one can reduce the probability of extreme negative returns over a 1-year horizon. We’re currently on the cusp between low and moderate interest which (according to this data) is an encouraging signal for those who are still accumulating.
4. The 2^nd phase is the narrow speculative sweet-spot when interest is higher than the accumulation phase but lower than the bubble. This phase has 12 monthly observations since 2012, only 15% of total observations. It is characterised by incredibly strong returns as the market kicks into hype and heads towards a bubble. Returns are stronger than the accumulation phase and historically the bottom decile of returns are also positive. The market tends to rally aggressively and during bear markets, when the price is falling, interest very rarely stabilises in this range. This is the sweat-spot for speculative activity but it also generates emotive reactions as holders experience substantial increases in wealth and non-holders experience FOMO. The challenge for investors is two-fold. First, one doesn’t want to miss-out on this period because the returns are sizeable. Second, one needs to considering selling near the end cycle to avoid the bubble.
5. The Bubble is the 3^rd phase of the bitcoin cycle. It is also characterised by fewer observations than the accumulation phase (only 12 monthly observations since 2012). While short-term returns can remain strong, subsequent 1-year returns have been weak during these periods. It is preferrable to reduce holdings during this phase and remain on the side-lines until the price has bottomed.

Summary, current conditions remain attractive for bitcoin accumulation. Strong returns are expected in the upcoming speculative phase but 1) this phase only last for a short period of time and 2) price volatility will be severe, which will make it very difficult for investors to contain their emotions. While strong returns are still possible, it’s ill advised to postpone purchases until the speculative phase. One can make a strong ethical argument for buying bitcoin at any price. And as long as the holding period is longer than 3 years, this argument holds for investors too. But buying in the bubble phase and potentially experiencing a 50%-80% drawdown thereafter is undesirable. It can turn these bitcoiners away from the underlying value of the technology, leaving them scared. As an investor, one needs to be planning to reduce holdings during the bubble phase, not increase.

Emerging Markets Realising Value

While global BTC interest is still pretty contained, interest in Emerging Markets is rising. All global citizens have potential use-cases for bitcoin, but these are more acute in emerging markets where currency devaluation and negative regulatory changes are higher probability events.

Historically, we have seen emerging markets lead the rest of the world. Given the lack of data history, one needs to be careful with all this analysis, but its another interesting development to be aware of. Its possible that growing EM interest leads the rest of the world’s interest in bitcoin.

Institutionalization: Commercial Traders increase Open Interest 400%

Total open interest rose to a new record high in August 2020, which is another confirmation of the growing interest in bitcoin. On one hand, this data is very bullish. On another hand, it also indicates the potential for downside volatility as leveraged speculators tend to quickly liquidate exposure if price momentum is less favourable. One needs to be careful if we witness a slowdown in open interest and price declines, like mid-March 2020. At one point in the week of March 13^th, bitcoin fell 57%! Of course, there was the added pressure from global funding markets that emerged during the height of the coronavirus panic. The most important funding markets in the world started to seize up in March, which caused investors to liquidate investment positions as though they were in a fire sale. Gold and bitcoin do not fair well under these conditions because they are very easily to liquidate. I don’t foresee another of these events as an immediate concern due to the Fed’s monumental liquidity injection efforts, but I remain vigilant because there’s a lot of complexity hidden in the global eurodollar markets.

For now, the trajectory remains towards growing open interest in bitcoin, which is supportive of further price gains. The sharp increase in open interest from the CME catches the eye. The CME is the centre of traditional financial market trade. CME open interest has increased by 400% since February, taking its share of total bitcoin open interest to 16% in August. This suggests that traditional financial market capital is finding its way into bitcoin, which is a very bullish development. Bitcoin is still a guppy in the ocean of traditional financial markets, but a small position that gains 100% plus can add a fair amount of returns to traditional asset managers. The more success bitcoin achieves, the bigger and more liquid the markets become, which allows even greater participation. At that stage participation shifts from hedge funds and small family offices, towards bigger asset managers and institutional players. Obviously this won’t be a linear trajectory. There will be ebbs and wanes along the path, which will probably align with bitcoin bull and bear cycles. For now, the bias remains firmly tilted towards a bull market and increasing participation from traditional finance. *Thanks to Travis Kling for pointing this data out.

Listen to George Gammon’s comments between 4-6 minutes in this interview for anecdotal evidence on growing traditional financial market participation.

Financialization: MicroStrategy puchases $250mn bitcoin

Talking about growing interest in bitcoin, MicroStrategy announced this week that they have purchased 21,454 bitcoin, approximately $250mn. This is not some gimmicky renaming of a product to include “crypto” or “blockchain” to boost the share price. MicroStrategy is a Nasdaq-listed company worth $1.2bn. They have staked reputation and $250mn of its capital on an emergent store of value. This is MASSIVE news.

“This investment reflects our belief that bitcoin, as the world’s most widely adopted cryptocurrency, is a dependable store of value and an attractive investment asset with more long-term appreciation potential than holding cash,” said CEO Michael J. Saylor. “We find the global acceptance, brand recognition, ecosystem vitality, network dominance, architectural resilience, technical utility and community ethos of bitcoin to be persuasive evidence of its superiority as an asset class for those seeking a long-term store of value.” What an endorsement!

Those who think that bitcoin is a speculative fad haven’t done the work. MicroStrategy have done that work and they’re positioning themselves as market leaders in the treasury management space. This is another major step in the financialisation of bitcoin. MicroStrategy competitors and treasury management teams across the globe now have their eyes open to the possibility of considering bitcoin as long-term store of value. If the bitcoin price increases, which I expect it will, pressure will grow. Not only will the success of bitcoin be measured by adoption rates and price increases, but MicroStrategy’s performance on the Nasdaq could be heavily influence by bitcoin. If bitcoin doubles, MicroStrategy’s market cap could increase by 20% (perhaps significantly more), which could make it one of the best performing listed companies in the world. Equity-only investors are now able gain access to bitcoin through purchasing a listed company, which is a first.

It’s going to be fascinating to watch MicroStrategy’s progress. My prognosis suggests massive benefits will accrue to this pioneering company.

Phase transition confirmed in techs

I don’t trade techs, but I think techs can provide a useful indication of market sentiment, momentum and confirm different phases in a cycle. As a hyper simple example, new all-time highs in gold confirms without any shadow of a doubt that it’s in a bull-market. Historically, this has proved to be very useful information despite it being obvious.

The evidence I’ve presented aligns with the price action in technical charts. Priced in US dollars, bitcoin has broken out of a downward trending support line that has held since the 2017 peak. This provides technical confirmation that a new bull-market is underway in price. A break about the $14,000 region would probably signal a very quick move towards all-time highs at $20,000. Thereafter price forecasts become a guessing game. I will rely on my indicators to provide an estimation of the speculative euphoria.

Gold is catching headlines because it’s at a new all-time high, but bitcoin has gained relative to gold since the start of the year. Technically, bitcoin also appears to be breaking out of a downward trend vs. gold that has held since 2017, suggesting the potential for additional bitcoin outperformance vs gold. Relative outperformance of bitcoin vs. gold in the order of 100% would take these assets back to the levels seen in December 2017. It is an outcome that I’d assign a greater than 50% probability of occurring over the next 2 years. As a reminder, I’m also bullish gold over this time horizon. Bitcoin’s scarcity and tiny market capitalisation relative to gold, combined with its digital decentralised nature, make it a much more exciting return prospect than gold. The bitcoin price has reflected some of this optimism, but it has yet to truly enter speculative frenzy. This is good news - the later the speculative phase emerges, the more time there is for accumulation. 

Price Ranges (not forecasts): Some readers have requested that I provide price forecasts so that they can explicitly quantify the opportunity presented in each research note. As a middle ground between my disdain for forecasts and the genuine request I’ll say this: I expect bitcoin to gain between 100% and 150% in the next year with a very wide range of potential outcomes. From current levels, investors should expect potential drawdowns of 25%/50%. On the upside, gains could exceed the 500% mark. While holders must be prepared for the downside, I assign a greater probability to the upside scenario than the downside. So, base case range of $23K-$28.75K over the next year, with downside risks towards $5.75K-$8.75K and upside potential towards $57.5K. I.E. Incredibly speculative with substantial potential and large risks, but the bull-market is underway and I assess this as one of the biggest opportunities in financial markets.

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