Weekly Thoughts #16: The sequence of events

 

 SEPTEMBER 13, 2018

At press time, the price of bitcoin is trading around $6500 or roughly 4% higher in the past 24 hours. The mid caps are up 7% while the small caps are up over 10%. Notable outperformers include NANO +35%, XVG +20%, VET +15% and BAT +15%. This overnight rally marks a sharp reversal from the price action seen earlier this week, when most of the market had moved lower by near double digits. Most of this weakness was situated with ETH and other altcoins. There’s quite a bit of speculation (often times ​heated​) on what is causing the immense selling pressure. Our view on the matter tends to line up with one of our core investment theses in that market prices today are not even remotely driven by fundamental factors. Rather the price of a digital asset in the secondary market goes through secular moments in time with outsized supply or outsized demand. In the case of ether, there aren’t just more more sellers than buyers – there are more ​synthetic sellers than buyers as well. It seems like ether bulls not only have to deal with scaling, security, usage of the underlying network and arguably their worst crisis of confidence in the public media. They have to now deal with the grim reality that the native token is in the ring with a large swath of sellers that include blockchain projects cashing out of into fiat, institutional investors redeeming out of locked up funds, short sellers on Bitfinex taking risky bets and levered short sellers on Bitmex taking even riskier bets. It could be a very long road ahead for any person, place or thing tied to the price of ether. ​We say that despite the recent strength​. In any case, here are our other thoughts for the week.


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1. Mr. Market wants to believe. ​At the start of the week, we saw the market move firmly into red territory by nearly double digits. Because of the organic correlation in liquid secondary market (namely due to the fact that most altcoin markets are quoted as BTC or ETH pairs), any move to the downside with BTC and ETH usually begets a similar move with the alts. However we noticed a few particular instances earlier this week where a handful of names saw momentary periods of green. There was evidence of clear outperformance versus BTC and ETH in names that were arguably too large to be pumped by any pump and dump syndicate. One name that comes to mind is WAVES, which announced the launch of smart contracts on its MainNet on September 10th. The asset saw a quick +25% spike higher, which was subsequently followed by a slow mean reversion to about half the spike. The name has since held its outperformance over BTC well for the past couple of days (indicated by the normalized price graph below). The reason why we highlight this move is because for the past few months “good” news has not translated into “good” price action. There were just too many technical factors driving the daily price swings. That dynamic has been a very strong point of frustration for value investors, venture capitalists and event driven traders that require this natural “good is good” market environment. We may be seeing this environment come back. With little overall macro conviction, market participants are itching for good news to drive conviction levels in individual names. On the flipside, this also means “bad is bad”. Because the market has very little conviction, any bit of bad news could also trigger a very pronounced downward move.

2. The customer is always right. ​The old adage was popularized in the early 20th century by a group of pioneering retailers. Ironically enough it promoted an attitude that was at the time very novel. It contradicted the previous paradigm of “buyer beware” and was meant to advocate that customer complaints should be treated in a way that customers do not feel cheated or deceived. Fast forward to modern times and it is a slogan that is still used amongst businesses – small or large. Even on Wall Street. We recall our time back on the big bank trading desk when our young analyst self would be forced to address client complaints head on. We’d work tirelessly just to make our clients lives easier (this on top of generating trading ideas, managing PnL, producing a daily note and reconciling with the back office). We’d build tools that automated manual processes. We’d create visual interfaces that represented data sets. We’d produce reports that improved decision making. We’d pretty much do whatever was necessary to improve the experience for our clients in any way we could. That paradigm is important, especially as we think about the predominant use cases of various cryptocurrencies. An asset that experiences annualized volatility in the triple digits is tough to promote as a store of value, however it is is even tougher to call it a medium of exchange. However even if vol comes down to a more stable level, we still will not be using it to buy coffee. Why? The process to transact is terrible. It needs to be improved in a meaningful way. And for someone that isn’t natively in the crypto marketplace (most of the world), transacting with a digital asset is a no go. A quick analog on the topic – when we see a new project or tech that involves improving transactions amongst the mainstream, we like to ask ourselves “will my mom use this?”. The answer 99 times out of 100 is a resounding no. The broad market is composed of regular people that are living their lives outside the bubble. They are not daytrading ETHUSD perpetual swaps on Bitmex. They are not following dozens of crypto personalities on Twitter in real time. They are not scanning Reddit. They are people that are busy with their own lives. And they use technology that improves their lives in some way, shape or form. They use credit cards because it’s easy and quick to swipe a card. They use Venmo because it’s easy and quick to press a button. They buy stuff on Amazon because it’s easy and quick on their phones. Until the process of transacting a digital asset is just as easy, the mass market will not be adopting any cryptocurrency as a medium of exchange. Full stop.

3. There’s value in paying attention to seasonality. ​Seasonality in asset prices has in the past been an active area of research. Many time-series exhibit seasonality that consists of regular and predictable patterns in the data that occur at regular intervals. The logic behind using seasonality to predict asset prices goes something like this: (1) asset prices are determined by the decisions of individual human beings and the interaction that occurs when humans buy or sell the asset, and (2) a large part of human behavior depends on human constructs around the calendar (think holidays, the work week, and other arbitrary dates created by businesses and governments). Although there is always the danger of data mining when looking for seasonal patterns, the reason behind why seasonality might exist in asset prices has some basis in sound logic. In fact, the majority of macroeconomic indicators have a strong seasonal component and government officials spend a lot of effort in developing models so that data can be reported on a seasonally-adjusted basis. In the equity markets, researchers have identified calendar-related anomalies surrounding turn of the year or month and holidays. Given that cryptocurrency markets are highly reliant on human sentiment and are rarely anchored to some sort of fundamental value, it’s not unreasonable to explore whether there is some sort of seasonality that exists. The following plot shows a calendar heat map of bitcoin’s four-week return. Each square represents a day and green means that the past four weeks experienced a positive return while red means the opposite. A four-week return was chosen to add some smoothing to the data so that it’s easier to see if prices are moving higher or lower, and the classification of positive or negative was chosen to deal with how volatility has changed over time as bitcoin has matured into a legitimate asset class.

To be clear, there’s only a few years of reliable bitcoin price data and looking at seasonal patterns might just be data mining, but a few interesting observations emerge:

1. In January of this year, there was a widely held narrative that the Chinese New Year was somehow responsible for the overall market sell off and that the market would recover afterwards. The story was that Chinese investors, who have historically had an outsized impact on the market, withdrew capital from the cryptocurrency market for expenses and gifts related to the major Chinese holiday. Although we personally question whether that is actually the sequence of events that is responsible for the market sell off (for example, why doesn’t it exist during the run-up to Christmas, the western world’s closest equivalent), major market weakness has been observed in January and February for the past four years which roughly lines up when Chinese New Year has occurred. An alternative narrative which may have more truth to it is that investors may defer selling until after January 1 so that any capital gains on the sale won’t be paid until the following year.

2. In March of this year, another narrative was put forward to try to explain the market sell off: again tax-related selling of cryptocurrencies but this time to cover capital gains taxes. Again, the expectation was that the market would recover after April 15th, the U.S. government-imposed tax deadline. Over the past five years, bitcoin has averaged a 110 percent return per year which generates a meaningful amount of capital gains for investors each year. Individual altcoins have experienced even greater gains. In each of the past five years, there has been weakness in the market in late-March and early-April as retail investors might withdraw capital from cryptocurrency markets to pay their taxes in fiat. There is historical precedent for retail investors selling assets for this purpose – in April 2000, following the peak of the internet bubble, the NASDAQ Composite fell 9 percent in the week leading up to the tax deadline.

3. Typically, the last three months of the year have periods where price gains are likely. Both this bubble peak in bitcoin’s price and the previous bubble peak in 2013 occurred in December. But the price history we have for bitcoin is limited, and there doesn’t appear to be any compelling narrative or logical explanation for why price gains are more likely in the fourth quarter of a year. There is a weak seasonality component to internet traffic with greater internet usage the fall and winter months compared to summer months. Also, some investors may delay selling until January of the following year to defer taxes. But neither of these explanations seem very compelling, and this may just be a coincidence that will not persist in the future.

A final note on any potential seasonality in prices: regardless if the sequence of events that underlying narrative consists of is true or not, if enough retail investors adopt the narrative and allow the narrative to affect their trading decisions, these seasonal narratives have the ability to be self-fulfilling. This year, the tax deadline narrative was widely shared and adopted and enough people acted on it such that after the tax deadline, bitcoin rallied from $7,000 to $10,000 in short order. Tracking retail capital flow, narratives connected to seasonality, and how widely adopted these narratives are may help in explaining market movements.

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

Portfolio Management Team

Thejas Nalval  | Kevin Lu

Disclosures

This Commentary is for informational purposes and does not constitute investment advice, any type of recommendation or an offer to sell or a solicitation to purchase any securities from the Element Digital Funds or an entity organized, controlled, managed by or affiliated with Element Capital Group, LLC (“Element Group”).  Any offer or solicitation may only be made pursuant to a confidential private offering memorandum which will only be provided to qualified offerees for careful review prior to making an investment decision. We aim to educate, report and/or opine on certain developments relating to the digital asset market. These are our subjective views, based on information and sources we believe to be reliable as of the date we publish, but we make no representations or warranties with respect to the accuracy, correctness or completeness of our opinions or any information herein and have no undertaking to update it.  Please do not rely on it.

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