Back in 2013, when I first started to look at crypto in detail, I soon concluded that it was a new asset class. That’s a big deal by the way, because new asset classes don’t come around very often. In the case of crypto, we have tokens without borders, that have no income, aren’t consumed, and are virtual in the sense that they are pockets of information. That is unlike anything that has come before it. An asset class should have a mind of its own, yet crypto seems to follow the fortunes of social media stocks. But will that always be the case?
In this piece, I shall show you why crypto is a cyclical, high-growth asset class and when it matures, a decade or two from now, it will morph into an economically cyclical asset. It will grow from today’s circa $100 billion collective worth and be propelled into the trillions. But when it gets there, and becomes a core part of our daily lives, it will move with the ebbs and flows of the global economy. Crypto is currently a high-growth asset. But on reaching maturity, it will resemble the economic characteristics of oil, banks and industry, much more so that it will mimic gold.
As a fund manager, who has specialised in multi-asset investing for over two decades, I strive to understand the macro-economic drivers that help to explain an asset’s performance. Naturally the “bottom up” analysis is hugely important (that is the fundamentals of the underlying asset such as growth, profit and dividends), and the “top down” factors (the external events such as the economy, interest rates, FX and inflation) that often dictate when an asset performs well or poorly.
Burgers and Coke
The underlying businesses of McDonalds or Coca Cola haven’t changed much over the years. Obviously, they have grown, and they have more products, but they are now mature businesses. Their shares have thrived in certain macro-economic environments and have been ignored in others. These companies have tended to enjoy the highest valuations when interest rates and inflation have been low yet have slumped when rates and inflation have been high, such as in the 1970s. Today, there is a consensus belief that low rates and inflation will last forever, and so these companies currently trade at historically high valuations.
Should inflation return, then investors in these companies should be prepared for disappointment. The same goes for other rate sensitive assets such as bonds and property. Investors have become used to low rates and inflation and have extrapolated this long into the future. That has rewarded certain industries, that require low amounts of capital, such as fizzy drinks and software companies, at the expense of capital-intensive industries such as natural resources, autos, banks and heavy industry.
The question I am trying to understand is where does crypto sit within this framework? Which internal and external factors drive it? How would we expect it to behave under different economic scenarios? These are important questions because institutional investors won’t embrace crypto as a mainstream asset class until they can make the case to their oversight committees that its inclusion will be beneficial over the long-term. And for that, there needs to be greater understanding of the bottom up and top down factors that drive it.
Bottom up crypto
The good news is that bottom up crypto analysis is relatively simple. Crypto is a network, and the valuation is directly related to the size of that network. The more people that use crypto, the more valuable it becomes. I founded ByteTree.com with this point in mind. The data we provide enables cryptos to be analysed using fundamental analysis that measures the crypto economy, coin supply, technical factors, exchange trading and other blockchain-related metrics.
Current data show us that the Bitcoin network sees $10 billion change hands each week (spend) and has an adjusted network value (sometimes referred to as market cap) of $85 billion. This means the Network to Spend Ratio (NSR) is just over 8 weeks, which compares to a historic average of around 6.5 weeks. The valuation is slightly high, but not material so. More importantly, spend slumped to $6 billion in February this year. That it is now $10 billion means the network is growing again, and that is a good reason to be optimistic. If the growth in spend continues, then the Bitcoin price will continue to rise.
So far, the main driver of Bitcoin’s price has been attributable to bottom up factors, especially the growth in spend. Yet there have been supply side factors that have also helped Bitcoin, such as halving of the mining reward, which leads to a fall in coin inflation. By my estimates, this has caused the price of Bitcoin to rise five or six-fold over the last ten years. But growth in spend has had a much larger impact on price; perhaps 100,000 times (depending how you measure the starting point). Yet for some reason, the crypto spend statistics seem to follow the fortunes of the internet in general.
You might think that crypto behaves like an independent asset class with a mind of its own, but there’s compelling evidence to the contrary. Over the past five years, the Bitcoin price has moved in step with social media stocks.
Bitcoin behaves like a social media stock
Bitcoin has massively out-performed the Solactive Social Medial Index (SOCL), rising by 11 times over the past five years, compared to two times for SOCL; hence the need for a log scale for Bitcoin. But you can’t escape the fact that the correlation has been extremely high. The consolidation periods, the bulls and bears have been in sync and this relationship is quite remarkable. Crypto appears to behave like a modern-day dotcom.
Top down crypto
Technology stocks, or more specifically, growth stocks, have some opposing characteristics to gold. Consider that gold made its low in the late 1990s, just as growth stocks peaked. And then again in 2011, growth stocks started a multi-year surge, just as gold peaked. While the relationship is imperfect, these dates are by no means coincidental. It just so happens that real interest rates had their major inflexion points at the same time. That is the 10-year bond yield less the expected rate of inflation, peaked at 4.7% in early 2000, and troughed at -0.8% in late 2012. That broadly matches the turning points of gold versus growth and vice versa.
Why is this?
It may sound odd that interest rates dictate our investment preference for tech stocks or gold, but it’s really very simple. When real rates are high, such as in the late 1990s, you can deposit money in the bank and earn 4% interest above the rate of inflation. That’s an attractive low risk option, and it explains why gold is unappealing during such times. Why hold the yellow metal when it earns no interest and money pays you handsomely to own it? During such times, you would have confidence in the future value of money.
But when real rates are falling, and ultimately go negative, gold’s store of value comes into its own. It is easy to understand why gold is attractive when real rates are negative. That means money is losing its purchasing power, and the banking system doesn’t compensate you for it. Look to Venezuela and similar situations for extreme examples of this. If you lived there, and held gold, it no longer matters how bad the economy becomes, as you have would have certainty. Gold is a store of value that effectively sits outside of the financial system.
But even if real rates are positive, yet falling, gold is still attractive. That’s because gold’s future value increases inversely to real rates. Markets are reasonably efficient, given what is known at the time. Gold becomes cheaper when real rates are rising in order to lure investors. Similarly, when real rates are falling, the price of gold rises.
This all makes sense because if you suspect real rates are going to fall, then confidence in money (not necessarily the economy) will fall and gold becomes more attractive. Conversely if real rates are rising, then gold is unattractive. When money is deemed to be stable, as the US dollar is today, then growth stocks offer you even more money in the future (growing profits), and so prices rise quickly. But you wouldn’t chase Venezuelan growth stocks higher, because the promise of earning more Bolivars in the future holds little appeal; indeed, gold will outgrow growth stocks in terms of Bolivars. Even in the US back in 2007, the US dollar was seen as unstable at the time, as it had been falling in value and inflation was rising. Back then, US growth stocks traded at much lower valuations than they do today, while gold was all the rage.
I hope this helps to explain why growth and gold are opposite assets. Growth likes real rates to rise, while gold wants them to fall. And if crypto behaves like SOCL, then it stands to reason that gold and crypto are more opposite than alike; despite the similarity of the supply side factors (limited coin supply etc).
Crypto is a growth asset today, but will morph towards value
Crypto is still young. It is little surprise it behaves like a growth asset while it establishes itself and gains traction. We know that because equities are worth around $75 trillion (Bloomberg world Index plus a bit), and property around $228 trillion (Savills estimate), gold around $7 trillion (commonly used guestimate) while crypto is still a tenth of a trillion, or thereabouts. If crypto thrives, huge growth lies ahead, and I wouldn’t be writing this if I didn’t believe that.
McDonalds and Coca Cola ceased to be a growth stocks many years ago, they have matured and are reliable earners. I suspect that crypto will be seen in the same way at some point in the future, once blockchain transactions occur by the billions each day without us even noticing.
Yet crypto doesn’t generate profits; its value lies in the volatile network. I can only assume that network volatility will fall ten or twenty years from now as crypto finds a lasting role in society. If so, it will become embedded within the global economy (immutable data, record keeping, transactions etc), and its usage will start to resemble GDP in a broader sense. And that’s an interesting thought because if that’s the case, it will start to behave like “value” assets in general. These include industrials, banks and natural resources as opposed to quality assets such as McDonalds and Coca Cola. Crypto will become cyclical and its network activity will mirror that of the global economy.
Quality assets have predictable cashflows such as bonds (the good ones), property, utilities, healthcare, and non-cyclical consumer stocks such as McDonalds and Coca Cola. When the crypto networks mature, and become ex-growth, I can’t see how they would join this group. Cashflows aside, you would need to see crypto reliably deliver CPI plus (say) 2% growth in spend, regardless of the state of the economy. More likely, they will behave like cyclical assets, such as banks, manufacturers, resources, and industrial commodities. That implies that in the future, crypto will offer inflation protection, but with economic cyclicality. Inflation protection is gold-like, but economic cyclicality isn’t.
Could crypto ever behave like gold?
And that’s the real difference between gold and crypto. Both offer inflation protection, but gold prefers money to be troubled while the economy is doing badly, whereas crypto would rather see the economy do well. Gold is a store of value under the very worst scenarios, pure and simple. Nothing else beats it when the lights go out.
Gold rose seven-fold between the late 1990s and 2011. On reflection, that is hardly surprising given what happened to the banking system, and the collapse in real rates. It has been lacklustre since, in US dollar terms, because US rates have been rising and the economy has much more buoyant than elsewhere. But outside of the US, gold is making, or is close to making, new all-time highs. This isn’t just in Venezuela, but in Sweden, the Eurozone, the UK, Australia, Canada, Japan and most emerging markets. In other words, gold is at, or close to, an all time high pretty much everywhere except for in the United States. And just as gold is riding high for most of the world, crypto is just emerging from yet another brutal bear market in 2018.
Gold and crypto are very different because gold is influenced by the value of money rather than economic factors. It is a trusted go-to safe haven, with history on its side. It’s productive role in society is marginal outside of jewellery, but it’s really good at one thing; at being a long-term store of value.
Crypto is a growth asset class, that is finding its place in the economy. When it does, we can reasonably expect the crypto space to be very much larger than it is today. But when it finally matures, it will become cyclical. In the year (say) 2045, you can’t reasonably expect crypto network growth to reliably follow CPI plus 2% year on year. If that was the case, it would be a quality asset. More likely crypto activity will contract during recessions and rise during the good times; just like commodities.
I can understand why Satoshi designed Bitcoin around the idea of gold. Limited coin supply has provided the backstop which has led to confidence. But I have shown that demand factors have been more important in driving the price. For crypto to resemble quality or gold, it would have to shrug off the world around it and act in a highly stable manner. So far it hasn’t, and I can only assume that it never will.
For the time being, crypto is a growth asset, and I very much hope an ultra-high growth asset. But growth doesn’t last forever and when it finally matures, it will become economically cyclical and resemble value. It will have more in common with oil and steel, than burgers or gold; and the same goes for social media.
So where should an institutional investor place crypto in their portfolio? Put it into growth and leave it there for a couple of decades. If you already hold growth stocks, then just sell some internet stocks, especially social media. They are highly priced and generally mature companies. That’s unlike crypto, which trades just above fair value and has everything to go for. It is hard to see internet stocks growing their networks by 1,000 times from here. But crypto is still getting started, and it might do just that.
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