It is critical to think about the implications of a bear market, whether it is over or not, and the risks that remain looming over the digital currency. While Laissez Faire returns are relatively stable when compared to the underlying asset of bitcoin, it preforms the least well in sideways-down markets. You’ll notice that currently Bitcoin is outperforming the algorithm by about 20%, whereas if Bitcoin begins to drop Laissez Faire will greatly outperform the spot price of Bitcoin. So let’s go over some fundamental events still in play that could cause a price drop after this sharp move upwards.
As always during bear markets, it’s important to consider potential factors that would cause further negative demand shocks. Let’s consider a few:
1. BITCOIN EXCHANGE HACKS OR FAILURES
Bitcoin exchanges and custodians play an important role in the ecosystem. When MtGox failed in February 2014, causing 6% of all BTC in circulation to be deemed lost, the Bitcoin price crashed by 50% in short order. Given that no one exchange today has achieved the market dominance of MtGox at the time, a similar shock is unlikely. However, I still see exchange hacks or failures as the most important source of potential negative demand shocks for Bitcoin in the coming 6 months.
A survey of the top 100 influential people in the bitcoin space was taken, asking custodians, exchanges, and hedge funds of the likely hood of exchange exit scamming, hacking, or other unexpected loss of funds.
Experts were most worried about Bitcoin exchanges, where most responses indicated an expectation that over 20% of exchanges will get hacked before the summer of 2020. Larry Cermak, analyst for The Block, estimates the total stolen from crypto exchanges currently at $1.3 billion with approximately 61% of the thefts in 2018 alone. While cryptocurrency custodians were perceived to be the least risky, the experts still estimated that before the summer of 2020 an industry wide 10–15% of custodians would suffer from loss of funds due to a hack.
2. MACRO-ECONOMIC DOWNTURN
While Bitcoin is historically not correlated with overall markets, its relatively high liquidity makes it an asset that could be used as a proxy for cash in the case of an equity or bond market downturn. This could lead to a situation similar to the 2008 paradox of the gold price declining by over 30% (from sales to raise cash to meet margin calls) coinciding with a record high demand for coins and bars. Without going into too much detail, let’s look at the S&P 500 through the lens of Schiller’s Cyclically Adjusted P/E Ratio (CAPE)—by many seen as a potential indicator of ‘irrational exuberance’. As you can see, US stocks are currently trading at a 36 multiple of 10 year earnings, which is expensive by historical standards:
We only can theorize exactly what will happen to Bitcoin if a broad economic downturn occurs in traditional markets begin to fall rapidly. Bitcoin can be seen as a risk-on asset similar to equities in the stock market. During market crashes, risk-on assets will generally be sold in order to move into steadier lower rate-of-return vehicles such as bonds.
Alternatively, Bitcoin can be viewed as a hedge against the US economy, as it is a sovereign currency that can be used anywhere – effectively separating it from any one financial system or government. Examples may include Venezuela, whom has adopted the use of Bitcoin since the complete devaluation of their currency.
The point being, there is no historical evidence to support how digital currencies will behave in a global, or even local recession.
3. SECONDARY BITCOIN MINING CAPITULATION
Because of their large turnover and capacity to hold or sell coins, Bitcoin miners have an outsized influence on the boom-bust cycles of the industry. Bitcoin’s supply currently increases by 3.7% annualized. This new supply is distributed among Bitcoin miners, who vie for the chance of receiving the ‘block reward’. This causes miners to collectively throttle the Bitcoin price: By hoarding during a bull market in order to maximize profits, the supply constraint pushes prices higher. Conversely during a bear market, miners will sell more coins to pay bills, which leads to increased price pressure. With a total hashrate of 44 EH/s, there are currently about 3.1 million mining machines in operation around the world. The most widely spread is Bitmain’s 14 TH/s flagship miner the S9, of which around 2 million were sold in total. Assuming specs similar to the S9 and electricity costs of 5 cents kWh, most miners can make a profit as long as the Bitcoin price is above $3,250 (The break-even point for 4 cent miners is $2,600 BTC, and for 3 cent miners $1,950). So there’s an argument to be made that should the Bitcoin price drift down towards $3,000, this could trigger another capitulation event in the mining space, where Bitcoin miners operating the fleet of outdated rigs go out of business and where their BTC holdings are liquidated to pay for the remaining liabilities. The scenario above is contradicted by last November’s 30% decline in mining difficulty, which was the largest drop in difficulty since the 2011 bear market. This sustained drop in hashrate strongly suggests that a huge amount of mining rigs went offline in that period.
As markets move from overvalued to undervalued, the assets are passed on from disillusioned “weak hands” to more dispassionate “strong hands”. These value investors are not in a rush and are happy to accumulate by buying the dips over quite a long time period. On the other hand, the investors who got caught up in the hype of the preceding bull market and who didn’t anticipate how long and brutal this bear market could become, they capitulate by selling into the price rallies. During the accumulation phase, the market will trade in a range: the weak hands, who are trying to get out of the market, take profit during rallies and thus create the resistance, and the strong hands, looking to accumulate, buy at the bottom of the range which eventually creates a floor in the price. This process can take a while: “Preparation for the principal movements in the market will very often occupy several months. This may often be preceded by a decline, in which large operators accumulate their stocks.”-—Richard D. Wyckoff, 1910 We saw a clearly illustrated accumulation pattern in the previous Bitcoin bear market when BTC traded in the $200-$400 range from February 2015 until May 2016.
During the rest of 2019 I’m sure we’ll develop a clear picture on whether we’re entering a real accumulation phase, or preparing to make new lows in the crypto markets. Until then, happy investing!
Opening Period 5/6 – 5/11