Sound Money

Bitcoin and the rest of the crypto ecosystem experienced a hair-raising correction in the past week but I expect the bull-market to continue deeper into 2021. The market structure might be changing slightly as institutions play an important role so we have to wise up to the risks they introduce. But we cannot be fearful merely because of the short-term volatility. In this article I cover 5 things that happened, 5 things learned and 5 reasons why the bull-market is not over. TLDR: Volatility is part and parcel of a technological advancement, bitcoin continues to process transactions, no central bank intervention was required to maintain healthy market functioning and, no, this is not the end of the bull-market.

5 Things that Happened

1) Exuberance whittled the foundation

In April 2021 bitcoin had gained more than 400% over the previous 6-months. In May 2021 Ethereum had gained over 800% in the previous 6 months. But those pale in comparison the increase in doge and doge derivative coins. Doge increased >1000% in 30 days in May. The market was hot! All those shiny new coins were pulling marginal bidders away from bitcoin. That created a less stable foundation for the key asset in the ecosystem. Bitcoin dominance fell from 60% in March 2021 to 40% in May – the lowest levels since the end of the December 2017 bull-market. Bitcoin remains the foundation of the crypto ecosystem. Low levels of dominance are unsustainable and should be watched closely.

2) Cheerleaders are unreliable & FUD is expected

I will write a separate article on energy FUD (fear, uncertainty and doubt) soon, but for the sake of this article this is what you need to know. Elon Musk flipped from a bitcoin supporter to critic. He particularly critiqued bitcoin mining’s energy consequences. The Tesla CEO’s twitter argument with prominent bitcoiners displayed a lack of understanding of the technical details on network scaling (see tweet below). This created a fair amount of market confusion. Some questioned whether Tesla might sell their bitcoin holdings. Musk has subsequently indicated Tesla will not sell its bitcoin holdings but clearly he triggered a loss in price momentum.

Given he has been punting Doge coin for months, people really should ignore what Elon Musk says about bitcoin*. But unfortunately he is the pre-eminent social, political and business cheerleader in the 2020s. *Some would argue that the opposite is true! You must watch Elon to ascertain which coin he is going to pump next -  I do not like this investment strategy.

3) Global macro remains a factor

Risk appetite in traditional financial markets paired back in May 2021 after a sharp rise in inflation expectations and a subsequent increase in bond yields. Plus, the IRS 16 May 2021 deadline may have triggered selling pressure. While bitcoin is creating an alternative financial system that may be more robust than the existing financial system, the interaction between the two systems is undeniable. I wrote in a recent piece that bitcoin does not hold correlations with traditional financial markets. This is not entirely true. Bitcoin’s bull and bear cycles hold a reasonably strong correlation with dollar bull and bear cycles (chart below). The dollar is the ultimate indicator of global risk – favouring risk when it is weak and favouring risk aversion when it is strong. If global risk tightens, there is no doubt that bitcoin feels a squeeze at the margin. There was a minor case of this in April and May.  

4) Technical price action

Support for bitcoin broke down in late May, leading to a dearth of large buyers when the price fell through the $50K mark. The chart below shows the quantity of bitcoin transacted on chain at various prices. There was a significant amount of price support in the $60K mark, but very little support below $40K. The lack of buyers, combined with leverage liquidations, saw the price unravel sharply between $40K and $30K.

5) Much to its detractors dismay bitcoin is alive and well

Despite a stressful week and significant pain for numerous new entrants, bitcoin is alive and well. No centralised entity came to support the market. Think about the amount of Fed support that would emerge if the S&P fell 40%. Bitcoin transactions continued to clear on chain without any hiccups. Individuals may have been margin called through the process and some institutions may have come under extreme pressure. Some institutions could even fail under this stress.

But no one will come in to save them. And that is a good thing! If an institution fails it encourages prudent business practices amongst the rest of the industry. Entities that made it through May 2021 will learn a few things about themselves, the market and risk.

5 Learnings from May 2021

1) Technical details are important in the short-term

In the long-term, these technical details do not matter. Bitcoin is a powerful technological revolution and its price will likely be orders of magnitude higher than it is today. But understanding the technical structure of this market like tax deadlines, technical price momentum can be important in the short-term.

2) Stick to the Strategy

If you do not have the time nor desire to understand these technicalities, then you have 3 options. 1) formulate a long-term strategy and prepare to sit through the volatility, 2) employ someone to manage the volatility for you or 3) you can sit on the side-lines.

Prices do not increase in a straight line. Volatility is part and parcel of bitcoin. I wrote a longer article about that here. You need a strategy to deal with the volatility.

3) Stay humble and aware

In hindsight the daily “should I buy doge?” calls over the past two months were a warning sign.

4) If you play with fire, expect to be burnt

Leverage is risky. If you are making use of this tool, make sure your risk management is good enough so that you will still be standing to fight another day.

5) Avoid hero worship

I did not lay out the red carpet for Elon when he arrived in bitcoin because bitcoin is far more important than one individual. This is as good a reminder as any; do not buy bitcoin because “Elon said so”, buy bitcoin because of the sound principles it represents.

5 Reasons the bull-market is NOT over

1) Valuation constructive

Price is well below stock-to-flow expectations

2) Flows to exchanges soft

Flows towards exchanges have started to increase recently, which also placed downside pressure on price. But flows have not reached 2013 or 2017 levels yet – not even close. We need to see more capital shifting towards exchanges before I expect bull market exaustion.

3) Long-term holders are not selling on mass

Coin days destroyed rises when long-term holders are selling. Long term holder selling has not risen anywhere the level seen at previous peaks.

This theme leads credence to the idea that this was a technical breakdown in the bitcoin price, probably influenced by the influx of institutional traders in bitcoin. Long-term holders appear to be buying bitcoin at these levels, not selling.

4) Leverage is being drained out of the system

If institutional money and professional traders are an increasingly important, then we need to watch leverage closely. Traders are more familiar with futures than self-custodying bitcoin. Futures volumes relative to actual bitcoin transactions rose above 120% earlier this year but has declined since March. Sharp liquidations on 19 May took this ratio down to 20% - the lowest levels on record. [I’ve included a Glassnode chart (of the same data) for the historical comparison since I do not have that full historical series]

Another way to view leverage is Open Interest (OI) relative to Bitcoin’s market capitalization (mktcap), which has also dropped substantially in the past week. I.E. There is significantly less leverage in the system. If we enter into an extended bear-market today it would more likely have to be driven by long-term holders capitulating and selling their holdings at a 20% to 30% discount to all time highs. I think that is a low probability event.

5) The Greatest monetary experiment in history continues

While global macro did tighten and place some pressure on BTC, we have not entered a sustained monetary policy tightening cycle. The Fed is planning to be behind the curve for as long as humanly possible. If you do not believe me, look at US real rates which have fallen to the lowest levels since the 1970s. It does not matter if CPI is transitory or not, the Fed is overseeing the greatest monetary experiment in human history. The dollar is weakening again in recent weeks, which should provide some support to asset markets across the board.

Bonus: Retail activity could ratchet up another notch

While it has been obvious the retail activity has been strong in the past 6 months, it also does not compare to previous cycles. Perhaps we will see a few more high-profile celebrities launch NFTs this year yet?

These are all merely my opinions and they do not constitute investment advice. There are reasons to argue that the bull-market could be over, including the fall in price below the 200-day moving average and the sharp decline in bitcoin dominance, which resembles the last bear market. You need to analyze the data yourself, assess your portfolio, appreciate your risk tolerance and position size accordingly. In the balance of probabilities the scales lean heavily towards a continuation of the bull-market and I am tentatively ratcheting up my risk allocation again in an effort to capitalize.