Weekly thoughts #11 - Humility will always be noble


July 11, 2018

At press time, the price of bitcoin is trading right around $6,400, a -3% move in the past week. Most of the large caps are following in lockstep (EOS the noteworthy underperformer at -20% week over week). The mid and small caps, given their natural higher betas, are trailing even more and are down 8-10% since this time last Wednesday. This recent weakness is somewhat of a sudden about face as the digital asset marketplace had previously been performing strong since the start of month. There’s a number of conspiracy theories going around the usual social media channels as to what the lead catalyst for this downward move may have been. A couple of the more popular narratives surround 1) the decentralized exchange Bancor experiencing a security breach overnight which resulted in $24M worth of stolen tokens and 2) Finnish central bank advisors going public with a study that called ‘the concept of digital currency a fallacy.’ Beyond that, there weren’t any real negative catalysts that we could see. Even those headlines themselves were not so bad as compared to what’s historically impacted the marketplace. Perhaps we are still just in a very weak market environment. Perhaps market makers have pulled back on their inventory accumulation algorithms for the summer. Or perhaps this was just the case of there being more sellers than buyers. In any case, here are some of our other thoughts for the week:

It’s time to view this new asset class for what it is: a new asset class. What we’re trying to say here is that using standard metrics and benchmarks to compare cryptocurrencies to conventional asset classes can sometimes be nonsensical. It doesn’t work. Not one bit. Annualized price volatility for the largest and most liquid cryptocurrency bitcoin dwarfs that of the largest, most liquid stocks. The time it took for bitcoin to move from peak to trough in a correction is a fraction of the time it took the Nasdaq to do the same post dot com bust. Intraday gyrations that fall within the 7% level, a level that has significance for stocks, are within the bounds of normal volatility for most cryptocurrencies. Anyway, our point with this narrative is simple. Is bitcoin volatile? Yes. Is the great correction of 2018 significant? Yes. Are we still many years away from meaningful mainstream adoption? Probably. Does the technology underpinning many cryptocurrencies have the potential for significant network effects to be realized? Yes. Will those networks be transformative in nature? Yes. Are we still in early stages with the ‘product’? Yes. Is the generation of young people in the world the most technology savvy in the history of mankind? Yes. Are they likely ready and willing to adopt cryptocurrencies as a part of their daily lives? Yes. Does this asset class have the potential to deliver significant returns that go above and beyond what more mature asset classes can deliver? YES.

The problem isn’t security breaches. We’re referring specifically here to the recent Bancor news. Many would argue that that event is the singular problem and the reason for the recent weakness. We however believe that’s not the problem. Not solely anyway. We believe the problem is really that a combination of realities that currently exist in the digital asset space. First, less than positive things continue to unravel with the technology which this usually results in a theft or hack. That comes with the territory with any new technology that is looking to disrupt entire industries. Before mainstream adoption, a number of challenges around scalability and security need to be solved. With developments such as the Lightning Network and Raiden Network currently being battle tested, the industry is headed in the right direction. That is a problem that will be solved. The real problem however is that never in the history of financial speculation has the retail investor been the main determinant for equilibrium price discovery while also being the main propagandist for all information (real or fake). Johny Bitcoin who can not only react emotionally to news headlines but he can also spread fear and uncertainty into the ecosystem by way of social media (and successfully). As long as retail investors continue to maintain their stronghold on daily price moves, there’s no balance in the cryptocurrency markets right now. There’s need to be more controls, more checks and balances. There needs to be more accountability for one’s actions or words (just like we have with traditional marketplaces). Until this world evolves to something that mimics a more regulated landscape, we will continue to see singular headlines drive prices +/- 7% on any given day. We’re headed in the right direction, it just may take some more time.

The most recent bubble and subsequent crash in the cryptocurrency markets is just one cycle in a cycle that has played out many times before, both in bitcoin’s history and the broader history of all financial markets. Forming economic bubbles appear to be deeply rooted in human behavior and no matter how many times they occur, we are unable to collectively learn from our mistakes and prevent them from forming in the future. Many of the theories that are used to explain their occurrence cite human cognitive bias or sociological factors.

Economic bubbles happen infrequently enough that it’s hard to remember what happened the last time around and each cycle is slightly different which makes direct comparisons difficult. But it is striking how much in common each bubble-crash cycle has in common. By happenstance, we recently came across the Wikipedia article for the dot-com bubble. A study of this bubble and other asset bubbles like this should be required reading for all investors. The similarities between the two bubbles run deep, but for this piece, we focus on one aspect: the macroeconomic environment at the time present prior to the start of the bubble.

The prelude to both bubbles played out with great similarity. In late 1995, the Fed reached a local peak of their monetary policy tightening cycle with an effective federal funds rate of 6 percent. This date is also indicated as the start of the internet bubble — Netscape launched their initial public offering at this time and on the first day of trading went from $28 to $71. Over the next several years, they gradually eased monetary policy by cutting interest rates with one exception in 1997. The Asian financial crisis, Russia sovereign debt default, and the collapse of Long-Term Capital Management forced the Fed to aggressively reduce Interest rates with three cuts in three months. The actions by the Fed started to give investors the perception that the central bank would be supportive and protective of asset prices. This, combined with a large tax cut and stimulative fiscal policy that was occurring at the same time, allowed investors to move further out in the risk curve and drove capital into high-risk internet companies.

The same macroeconomic conditions that existed back then happened prior to the most recent cryptocurrency bubble. The Fed cut interest rates to zero in the aftermath of the global financial crisis, engaged in even more stimulative monetary policy through several rounds of quantitative easing, and most recently infrastructure spending, tax cuts, and stimulative fiscal policy have also created an environment where investors are comfortable taking risks.

The bursting of the internet bubble was also driven in part by macroeconomic conditions. Concerned with elevated asset prices, the Fed began to sharply raise interest rates in 1999 and finished their tightening cycle in March 2000 with the goal of taking back some of the liquidity they had injected into the economy due to those international crises. The NASDAQ peaked in that same month. Similarly, the recent cryptocurrency bubble peaked in December 2017, after the Fed raised rates three times in 2017 and other central banks around the world begun to conclude their quantitative easing programs and turn to the path of monetary policy normalization.

These patterns suggest that conditions would be ripe for another bubble in cryptocurrency markets if many countries around the world experienced a recession which would force central banks to once again ease monetary policy and pump liquidity into markets. Interest rates in many developed world countries are close to the zero bound, however, which may limit the tools available to policymakers and force them to be even more inventive the next time around.

Humility in this game will always be noble. The one thing most fund managers, blockchain companies, advisors, investors and traders in this space have realized in the past year is that this market has more factors that drive price action every single day than anyone person or entity can account for. We’ve noticed that sometimes this market takes a form of its own with elements of both serious autocorrelation as well as sheer unpredictability occurring almost simultaneously. So that being said, we oftentimes take a longer term view of the marketplace in that we tend to refrain from calling absolute tops and bottoms and focus more on calling trends. Some market pundits consistently do the opposite and find it to be their purpose to consistently put out price targets again and again. We find it much more sensible to identify if the market is in a trend or not in a trend. W Some of our peers have come to similar conclusions however have taken quite a bit of flack through the retail community as a result. We believe admitting that this is a nascent market with short term movements that are often difficult to fully understand is a sign of ultimate humility. It is a signal that you hold respect for this marketplace as well as a show of confidence in one’s owns abilities. Anyone who says otherwise has an agenda and their words should be taken with the biggest grain of salt possible. On that note, we end with a whimsical quote that does well to wrap up this sentiment.

“Number one rule of Wall Street. Nobody…and I don’t care if you’re Warren Buffett or if you’re Jimmy Buffett. Nobody knows if a stock is gonna go up, down, sideways or in circles. You know what a fugazi is? It’s a whazy. It’s a woozie. It’s fairy dust. ”

– Matthew Mcconaughey in Wolf of Wall Street

Thanks for reading everyone. Questions or comments, just let us know.

Portfolio Management Team

Thejas Nalval  | Kevin Lu


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