We review current market dynamics, risks we are watching, and a look at the potential road ahead.
QUICK TAKEAWAYS:
Fed’s continued attempts to stymie inflation are depressing asset prices across the board.
Bitcoin cycle metrics, measured against history, may help us understand the current cycle.
Like in previous market cycles, counterparty risk has reared its ugly head.
The Anatomy of the Crypto Bear
As prices for cryptocurrencies, including bitcoin, continue a downward trend, many investors have asked about the current state of the market. With a bear market for crypto fully established, we thought it would be valuable to readers for us to explore current market dynamics, risks we are watching, and a potential road ahead. The title of this piece is a reference to Russell Napier’s The Anatomy of the Bear, which chronicled four of Wall Street’s great market bottoms.
MACROECONOMIC BACKDROP
Inflation Has Yet to Be Tamed
The issue facing financial markets for nearly the past year has been persistently higher-than-desired inflation. On the morning of Friday, June 10th, the May reading of the Consumer Price Index showed that inflation continues to be an issue despite the Fed’s attempts to curb it by increasing the Fed Funds rate and implementing quantitative tightening. Not only did inflation numbers come in ahead of expectations, but based on 2-year stacks, they show no sign of deceleration.
This is relevant because the monetary response to higher-than-expected prices is higher interest rates, which is negatively affecting asset prices from stocks to bonds to crypto. While the actual Fed Funds rate has only moved 0.75% since the hiking campaign began in March, market expectations for the Fed Funds rate have soared. Looking at the Fed Funds Rate futures, as of yesterday's close the market is expecting about 4.1% a year from now.
Monetary Policy is a Blunt Instrument
If we could describe this dynamic simplistically, the economic issue at the moment is inflation, meaning high prices for goods and services. Going back to our macroeconomics basics, price is the intersection of aggregate supply and aggregate demand. Certainly, part of the reason for high prices has been due to the supply function. The world economy is still dealing with supply constraints, parts shortages, and the production fallout caused by COVID-19, plus we are amidst a global conflict with the Russia invasion of Ukraine. Meanwhile, demand has been persistently strong, driven by access to cheap money (monetary stimulus), direct payments and spending (fiscal stimulus), and, until recently, financial asset price appreciation. Unfortunately, the Fed has no control over aggregate supply; the only lever in that equation it can affect is aggregate demand. It does this by removing money from the financial system, thus raising the cost of money and destroying the propensity for households and business to consume. This has set the stage for a decline in asset prices, including that of bitcoin.
BITCOIN CYCLES
Past Cycles Show Declining Drawdowns
With a crypto bear market fully underway, we wanted to look to bitcoin’s previous price cycles for clues about the current drawdown. These price cycles, which peaked in 2011, 2013, 2017, and 2021, have occurred roughly every 4 years. A couple of observations come to mind when looking at the progression of these cycles. First, the return from the start of each cycle to its peak has declined with each successive cycle. This makes sense as the sheer market size of bitcoin prohibits it from keeping up the same percentage returns from cycle to cycle. Second, even though these cycles have typically ended with drawdowns of over 80%, the magnitude of these drawdowns have lessened over time. While we do not have a crystal ball as to when this drawdown ends, there is reason to believe that the trend of shallower drawdowns may continue as institutional investors, who entered the space, in the most recent cycle, are still strategically underweight the asset.
Cycles Continue to Be Centered around Halvings
We have written about Bitcoin halving cycles in the past, but it is worthwhile providing a refresher given the current backdrop. As a reminder, every 210,000 blocks, about every 4 years, Bitcoin reduces the reward paid to miner of a block, called the block subsidy, by 50%. This event is called a “halving.” And while there have only been 3 halvings in Bitcoin’s existence, they all curiously have occurred in the middle of bitcoin cyclical highs.
Looking a little deeper, one of the strange repeating patterns is that cycle peaks and troughs appear roughly 1/3 and 2/3 of the way through each of the halving cycles respectively. The one exception was the first cycle, which was longer in terms of number of days and did not have reliable price data until it was well underway. If this pattern repeats, that would imply a market bottom somewhere near the end of 2022 or beginning of 2023.
VALUATION & SOCIAL ENGAGEMENT
Market Cap to Realized Value Ratio Breaches 1.0x
Market Cap to Realized Value (MVRV) is a valuation measure whose main purpose is to determine cyclical highs and lows. MVRV represents the ratio of bitcoin’s current market cap to its “realized cap,” which values each coin at its price the last time it moved. In that sense, it a measure of how much of a profit (or loss) holders are sitting on. If the MVRV is 2.0x, for example, then the current market cap of bitcoins is double the value at which holders obtained those bitcoins. MVRV has historically tended to trough under 1.0x, at which point the aggregate market is at a loss. On Monday, MVRV fell under 1.0x, with current levels at 0.96x.
Metcalfe’s Law Implies Bitcoin is Trading at a Discount
One way we think about valuing bitcoin is through something calling Metcalfe’s Law, which states that a network’s value is proportional to the square of the number of its users. Using number of Bitcoin addresses as a proxy for users, this rule predicts a price at each point in time. This has done a reasonably good job of explaining the appreciation of bitcoin’s price historically. Notably, current prices are trading at a hefty 50% discount to the model price of $44,519.
Social Media Engagement Peaks
Two common measures of user engagement with crypto are numbers of tweets and number of Google searches. Unsurprisingly, these metrics tend to peak around price peaks and trough around price troughs. Both measures have already peaked and are decreasing. One observation about past cycles is that market troughs tend to be marked not by attentive aversion but by investor disinterest.
COUNTERPARTY RISK
Fears about Lender Celsius Highlight Counterparty Risk
Another characteristic of bear markets has been counterparty risk. The seminal example of counterparty risk was the 2014 bankruptcy of the Mt Gox exchange. Most recently, major crypto lender Celsius announced on Sunday that it had halted withdrawals from its platform. As of their last reported number on their website, on May 17, Celsius had $11.8B in client assets on its platform earning yield. Our understanding is that Celsius generates yield for depositors by lending out those assets to hedge funds and market makers and by various principal market activities, such as participating in various DeFi activities. According to blockchain analytics, some of these activities include lending on Aave and Compound, staking ETH on Lido, and borrowing Dai through MakerDAO, presumably to lend out. Unfortunately, some of these activities has resulted in losses. Celsius reported it had lost $120M in the BadgerDAO hack and it either narrowly escaped and/or was partially responsible for the LUNA/UST fiasco.
Risk management aside, Celsius’s issues likely represent a classic liquidity mismatch problem; too many depositors demanded liquidity, and too much of the money was locked up into longer-term investments. There may be knock-on effects to other counterparties as well. For example, Asia-based crypto hedge fund Three Arrows appears to be having issues that could be related to Celsius, though it may just be another symptom of the risk-off environment. It is likely that we hear about other crypto players facing existential crises as the bear market continues. As Warren Buffet once wrote, “you only find out who is swimming naked when the tide goes out.” We are certainly finding out now.
Final Thoughts
Cycles have been a persistent feature of bitcoin markets since its inception and this current phase seems to be no exception. Many of the factors at play with this cycle stem from macroeconomic impacts, counterparty risk, and issues within DeFi, issues that are exogenous to the Bitcoin network. While history is not a guarantee of future outcomes, investors should take comfort in the fact that this is a place we have been in several times in the past and every time the asset has come back to grow its user base, improve its technology, and increase its institutional acceptance.
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