Bitcoin has gone wild – it’s up +10% in the last 24 hours; it’s up +100% for the month; and it’s up +178% year to date. Bitcoin is the best performing asset by a country mile. Simply put, it is the “Big Long”.
So what’s behind the move?
1.) Bitcoin Scaling Agreement – this is some inside baseball, but an agreement was reached this week on the path toward upgrading the bitcoin network. Prior to this agreement there was a very real chance that bitcoin could have split into 2 coins. IBKHO, this split (aka – a contentious hard fork) would have had an almost fatal impact on bitcoin. Reaching an agreement not to split the coin and agreeing to upgrade the network removes the existential threat. More importantly it means that the bitcoin network will now have the capacity for Web 3.0 apps to be built on top. This solidifies bitcoin as the leading payment protocol for Web 3.0.
2.) Korea and Japan – Earlier in the month the volume of bitcoin traded in Japan was soaring – it still is, but South Korea is coming on strong. As of this morning bitcoin was trading as high as $3700 on the Korean exchanges, a premium of over 20%. Getting fiat money out of Korea is almost impossible, which means the arbitrage opportunities are limited and by extension there are very few market forces to close the premium.
3.) Fidelity Embraces Bitcoin – At Consensus on Tuesday (the largest blockchain conference), Abby Johnson CEO of Fidelity announced that Fidelity customers will be able to see their bitcoin balances when they log into their Fidelity account. Fidelity has partnered with Coinbase to integrate bitcoin balances. The sheer size and scope of Fidelity ensures that bitcoin will continue to gain mainstream acceptance.
4.) Web 3.0 – While bitcoin certainly has a safe haven appeal and can serve as a hedge against political chaos, there is another use for bitcoin. People are finally starting to understand that Web 3.o will be a decentralized web and will need new protocols to replace the likes of HTTP and TCP/IP. The new payments protocol for Web 3.0 is bitcoin.
So are we in a bubble?
Probably, but it is not a “terminal bubble”. There is no question that we are in the middle of a price frenzy. There will be a correction and it could be severe BUT its unclear if that correction will start from current prices of $2700 or from someplace much higher. That being said, even at current prices bitcoin is vastly undervalued. To get an idea of how undervalued, consider that at current prices the total amount of bitcoin outstanding is $44 billion, while the total value of all the gold in the world is about $8 trillion. If bitcoin reaches only 5% of the total value of all the gold, then the price would be $24,000 or almost 10x higher.
It worth repeating, that while bitcoin is a revolutionary and disruptive technology it is not immune from the very human emotions of fear and greed.
The price of bitcoin has reached a new all time high today, touching $2000 on the Bitfinex exchange. This move puts bitcoin up +48% for the month and +106% YTD. There is no other asset class that can touch this performance.
What’s behind the move?
1.) Political uncertainty in the country with the world’s reserve currency (that’s the US for those of you who have not been reading Russian newspapers)
-bitcoin offers portfolio diversification to those worried about the political chaos in the US leading to a dollar drop
2.) Japanese investors piling in
-Japan enacted a law in April regulating exchanges and opening the door to institutional and retail investments in digital currencies.
-Bitcoin trading in now dominated by the Japanese Yen with 43% of the daily volume; followed by US Dollar at 30% and Chinese Yuan at 7%.
3.) Two big conferences next week in NYC
–Consensus and Token Summit next week are conferences where a lot of new projects and developments are announced.
-investors are buying ahead of the conference in anticipation of big news.
Does This Parabolic Move Make BK Nervous?
As much as BK believes in the long term prospects for digital currencies, anytime a market goes parabolic, alarm bells go off for the skeptical trader in BK. Bitcoin, Ethereum and other digital assets solve a lot of real world problems, but they do not solve the problem of human greed and fear. Digital currencies are subject to the same laws of human behavior that drive every other asset class.
While the rest of the financial markets have been sleepwalking into May, the new asset class on the block has been a bit of a peacock. Bitcoin has strutted in full plumage to rise +18% this month…yes this month…as in May…which is 5 days old. The proximate cause of the rise is Japan, the Winkelvoss ETF, and a software upgrade.
First Japan – in April, Japan declared bitcoin an official means of payment. To be clear it is not legal tender, but its also not illegal to use it. Further, many of the major Japanese banks are preparing to begin trading bitcoin as currency, just like yen, euro and dollar. It appears this has legitimized bitcoin as a currency and caused an influx of new money.
Second the ETF – the BATS exchange (where the Winkelvoss Bitcoin ETF was scheduled to trade) appealed the SEC rejection of the ETF and the SEC agreed to take a second look. The primary reason for the original rejection was the lack of regulated exchanges and the inability of the SEC to monitor and prevent manipulation. As the space matures, it is possible that the ETF is approved, but in BK’s opinion the exchanges are not ready for prime time.
Third the software upgrade – Bitcoin desperately needs to increase the amount of data that can travel over the network. This is a good problem, as so many people want to use the network that it has become congested. There has been a contentious and damaging civil war within the bitcoin community over the best way to upgrade the network. In the last few weeks, the solution presented by one side (Bitcoin Unlimited) has proved to be an unstable solution. For the time being, this has taken the existential threat of a split into two coins off the table. However, this threat still remains and is BK’s biggest worry.
Can we go higher? Sure. Assuming current growth rates hold, BK’s fundamental value for bitcoin at year end is $2800.
As euphoria and complacency spreads across invest-landia there is one corner of the world that may not be doing so well. China has been making concerted effort to reign in its self-inflicted credit bubble. In the last few trading sessions we have seen the economic slowdown in China manifest itself in weaker commodity prices and weaker commodity currencies, especially the Aussie Dollar. Adding to the concerns of a slowdown was a weak Caixin PMI that fell from 52.1 to 51.2 and was below expectations. When viewed alone this decline in PMI does not appear to be a warning sign to investors. However, if the trend in loan growth continues to fall (as expected) then it’s quite possible to see the PMI drop below 50, or contraction territory.
What’s fascinating (at least to a currency nerd like BK) is that the economic indicators have turned lower at the same time the Chinese currency is approaching a decision point. For all of 2017, the Yuan has traded in a tight range, coiling like a snake waiting for its next attack.
Given the widely held assumption that the Chinese government keeps a tight control on the release of economic data AND that it controls the price of the currency, it’s reasonable to expect continued economic weakness to show up in the Yuan before it shows up in the official data. Therefore, BK expects to see the Yuan move lower before the economic data turns lower. It’s decision time for the currency and it does not appear to BK that anyone is paying attention.
It’s make or break time for the shiny metal – since the 2011 high of $1920, gold has dropped -33% and now it’s challenging the six year downtrend.
The bullish and bearish case for gold centers around interest rates and inflation, or in Wall Street speak “real interest rates”. The real interest rate is calculated by subtracting the rate of inflation (CPI) from the interest rate observed on government bonds. For the mathematically challenged there is an easier way – just look at inflation protected Treasuries or TIPs rates.
The following chart illustrates the relationship between gold and real rates.
BK will make the explanation really simple: if the blue line (real rates) is going down then the red line (gold) should be going up. This happens because gold costs money to store, so as the real amount of money earned on bonds drops the incentive to hold gold increases.
So what does this mean for our inflection point? And what is the signal coming from the price of gold?
If gold breaks the six year downtrend, then the signal is that bond yields will be lower than inflation. Either inflation will increase or bond yields will drop…or both.
The fact that the 10 year US Treasury rate just dropped below a key support level makes BK lean toward the falling yield explanation for gold strength.
For BK’s part he is already long of gold betting that it will break the six year downtrend. Of course market validation is the only arbiter and BK is hyper-vigilant that the downtrend is respected and gold could reverse course.
This might seem like a shocking headline from BK, but it is inspired by Warren Buffett suggesting the US stock market is cheap when compared to 10 Year Treasury yields. To be clear -BK is not, and does not, make a determination of cheap v rich valuations – BK’s investment style is rooted in human behavior rather than valuation. BK is simply pointing out what a few investors may be using as a “reason” to buy stocks.
In the past, Buffett has championed a valuation metric based on Total Market Cap to GDP – and by this metric the US stock market is significantly overvalued. The website Gurufocus does a great job of tracking this metric – currently total market cap to GDP is 130% or significantly overvalued.
The only other time the market was more overvalued was in 2000, when the metric reached 150%. So why is Buffett saying the market is still cheap?
It all has to do with rates. Using the Fed Model, which compares S&P 500 Earnings Yield to the 10 year Treasury rate, one finds that there is a lot of room for stock to run. Forward S&P 500 earnings are $134, when we divide this by the current price of the S&P 500 (2376) we get an earnings yield of 5.6%. It is easy to see that earning 2.3% on a 10 Year note is less desirable than earning 5.6% on stocks. BK suspects this is why Buffett is still buying stocks.
Assuming the earnings yield remains stable, then one might say that stocks are cheap until the 10 year rate rises to 5.6% – at this point stocks would be fairly valued.
BK will leave you with a little food for thought…When was the last time the 10 Year Yield was above 5.6%? A: In 2000.
In the last 24 hours, bitcoin has hit an new all time high on speculation that the Winkelvoss Bitcoin ETF (COIN) will be approved by the SEC. The new high above $1220 surpasses the 2013 high when an algo associated with the now defunct Mt Gox exchange went haywire. Over the last 4 years, bitcoin has passed multiple milestones and tests – it has come out the other side a strong, stress tested currency. It’s resilience is likely contributing to the speculation that an ETF “approval” is likely. The SEC has until March 11, 2017 to deny the application for the Winkelvoss ETF – if the SEC does nothing then the ETF is implicitly “approved”.
Investors are speculating that a last minute update to the ETF filing is a sign that an SEC blessing is forthcoming. The update concerned what is known as a “hard fork”, which is akin to a software upgrade. However, there is a huge difference with a digital currency upgrading software vs something like Microsoft Word. If Microsoft updates Word and some users choose not upgrade its not a big deal – but with a digital currency if all users do not upgrade then there is the potential that the currency splits into two versions – this could have a detrimental impact on the value.
The market euphoria over the ETF is not consistent with analysts estimates and prediction markets. There is one thinly traded prediction market that is indicating a 45% chance of an ETF approval.
On the other hand, Needham estimates that the chance of approval is 25%. IBKHO the argument against approval of an ETF is not very strong. It has been argued that bitcoin to too thinly traded to support an ETF – but bitcoin liquidity is similar to a mid-cap stock and there are plenty of ETFs that contain mid-cap stocks. There is a strong argument to be made that initially $300m could flow into the ETF and that would have a disproportionate impact on price – this is the only argument that actually holds water, but its unclear if this matters to the SEC.
Another argument is that since most of the trading occurs in China the SEC would be reluctant to approve an asset that trades in a potentially unfriendly location. However, in the last few weeks the PBoC has reduced leverage at Chinese exchanges and Japan has now become the top trader of bitcoin. In fact, it is widely expected that major Japanese financial institutions will begin trading bitcoin in 2017.
BK’s bet is that the ETF gets approved – but to be clear I am not making a specific bet on that outcome. To BK, bitcoin and other digital assets are a new asset class for investors that are grossly undervalued relative to their potential use cases. In my view, this is a once in a generation investment opportunity that warrants a long term perspective.
Yep, that’s right – despite record high stock prices and reports that the economy is accelerating the truth is the economy stagnated in January. The latest release of the Chicago Fed National Activity Index (CFNAI) indicated a decline in economic activity led by industrial production.
The 3-month moving average of the CFNAI was -0.3, down from -0.2 in December. A reading near zero indicates that the US economy is growing at trend – which appears to be near 2% over the last few years. While this is not a disaster it does indicate a deceleration in the economy. BK has developed a GDP forecast from the CFNAI which still is indicating GDP growth above 2.7% over the next 4 quarters.
This forecast is broadly consistent with the 10 year yield at 2.4% and the Atlanta FED GDP now which is indicating 2.4% growth. The problem for stock market investors is that the consensus estimate for S&P 500 eps growth from 2017-2018 is +12% – it is going to be very difficult to achieve 12% eps growth in an economy that is only growing at 2.4-2.7%.
The bottom line: now is the time to be cautious and taking profits rather than initiating new positions.
Late on Tuesday February 21, 2017, the Mexican central bank (Banxico) announced a $20b currency swap arrangement designed to stop the Peso from collapsing. The first swap auction will occur on March 6, 2017 and will have a similar effect as Banxico selling US Dollar futures up to 12 months out. The immediate impact was a 2% spike in the USDMXN rate.
The reason Banxico chose the swap, as opposed to direct intervention, is because the swap is a leveraged agreement which means it won’t deplete FX reserves at the same pace as direct intervention. Technically these swap agreements are not a claim on Mexican FX reserves BUT in reality Banxico is not going to default on the swap as long as they have FX reserves.
This type of levered quasi-government backed arrangement can work for a long time, until it suddenly doesn’t. The breaking point comes when Banxico’s short dollar position becomes so large that counter-parties issue a margin call. Mexico is a LONG way from having this happen, but this is how the movie ends.
In the short to medium term, this move should prove to be successful in halting the decline of the Peso. The unknown is the long run impact. For BK’s part, he will be waiting for the trade to turn against Banxico before committing sizable capital to a Peso trade.
Passive investors don’t care about President Trump. This is the only conclusion that BK can draw after watching the US equity market shrug off a disturbing, albeit entertaining press conference yesterday. BK was confounded by how “the market” could still think that President Trump will get any of his agenda off the ground with the chaos surrounding him – but then he realized passive investors are nihilists man, they believe in nothing.
The relentless charge higher in US equity indexes makes a lot more sense when you realize all the money pouring into passive index funds doesn’t care about valuation, tax reform, protectionism, Obama Care or anything else. As long as the money keeps flowing into index funds the stock market can chug higher. The risk, of course, is that the price becomes more and more detached from reality. It’s only a matter of time before somebody declares that index investing has created a permanently high plateau.
Eventually this will all end – probably when the great migration from active to passive investing is complete. The trick for the active investor is to step off the nihilist ride just before you get a bowling ball to the groin.