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.
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.
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.
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.
What If the Yuan Strengthens?
Everyone and his brother and his brother’s cousin’s hairdresser – are expecting the Chinese currency to weaken. But what if it doesn’t? There are three reason’s why it is in China’s best interest to have a strong currency:
1.) Capital Flows
The outflow of capital has been well documented and with FX Reserves below $3 trillion China is perilously close to a currency crisis. The IMF estimates that a country of China’s size needs approximately $2 trillion in reserves to operate the economy. This means the cushion for China is less than $1 trillion – this may seem like a lot, but with $100b month outflows it would take less than 10 months for China to reach a crisis. In short, China needs a strong currency to stem capital flows.
With inflation picking up China may indeed get a strong currency. The most recent reading on both CPI and PPI show inflation at 5 year highs.
To stem the tide of rising prices, China may need to raise interest rates – which could result in a strong Yuan. Moreover, a strong Yuan would help keep import prices down and in turn could reduce inflation.
Finally, with the approval of Steve Mnuchin as Treasury Secretary, the door is wide open for Trump to declare China a currency manipulator. The claim would be that China has been artificially keeping its currency weak. Of course, the opposite it true, but alternative facts are in vogue. If China strengthened its currency then there would no basis for a Trump attack.
What would this mean for asset prices? Gold would likely be the biggest beneficiary as a weak dollar would be the order of the day. Equities and commodities would also benefit. But there is a dark side to a stringer Yuan. China is in the middle of a credit bubble – if rates increase then the entire bubble could pop.
Is the Stock Market Heading Toward a Blow-off top and If So What Does That Look Like?
The good news is, we have a tool to measure extreme market moves; the bad news is because the future is dependent upon unknown decisions made today it is unknowable. However, we can observe fear and greed, and we can define when those distinctly human emotions reach extremes. There is a plethora (yes, a plethora) of research on financial market bubbles, but for BK’s purposes he likes research that is objective, can be replicated and can be tested. Those who want a deep dive should read the work of both Jeremy Grantham and Cliff Asness, both have done groundbreaking work.
In the simplest terms, the extremes of fear and greed can be observed when markets stray far from equilibrium. We can define equilibrium as the trend and the extremes as a 2 standard deviation move from the trend. Armed with these definitions we can look back at bull markets and look for similar patterns of human behavior.
If the research and BK’s thesis are valid then what we should observe is that major stock market tops occur when the price reaches an extreme (defined as 2 standard deviations from the trend). Let’s go to the charts.
BK used the Dow Jones Industrial Average because of its long history. The following charts are of every major bull market since 1921 overlaid with a regression channel. The middle line of the regression channel is the trend and the upper and lower lines mark a 2 standard deviation from the trend.
What do every single one of these bull markets have in common? They all ended with a blow-off top that resulted in the price breaching 2 standard deviations from the trend.
What does the DJIA look like today?
2009 – 2017
Based on this single indicator one might conclude that the DJIA would need to breach 21k before we could define this move as a blow-off top. To repeat what BK wrote earlier – the future is unknowable – but if the DJIA breaches 21k AND we see a deteriorating economic landscape then the conditions would replicate every other blow-off top.