By Justin Pawl, CFA, CAIA, CFP®
Last Week Today.
- Minutes from the Federal Reserve’s recent meeting revealed that several FOMC members want to begin discussing tapering soon.
- The European Union fell into another double-dip recession, recording negative growth in Q4 2020 and Q1 2021 after fumbling the vaccine roll-out. The silver lining is that the contraction was shallow and, with recent improvements to their vaccination program, the downturn should be recouped quickly.
- The Wall Street Journal reported it expects Iran will reach a nuclear deal soon, ending oil export sanctions. If this comes to pass, OPEC will need to keep existing production cuts in place to maintain pricing (oil is currently trading at ~$64 per barrel for WTI and ~$67 for Brent).
- IHS Markit PMIs (Purchasing Manger Indexes) for May were the highest on record. A lesser followed data set than their better-known cousins, the ISM surveys, which include 400 companies, IHS surveys encompass 800 small, medium, and large businesses operating in the U.S. Manufacturing rose to 61.5, and Services jumped from 64.7 in April to 70.1 in May. The economy is on fire, and strength is broad-based.
- On the topic of the economy, the Atlanta Fed’s GDPNow model is tracking Q2 annualized, real growth of 10.1%. This model tends to be fairly volatile, especially early in the quarter. However, giving credence that growth accelerated in the second quarter, the GDPNow’s associated Blue Chip consensus survey of economists forecasting Q2 growth of ~9%.
- Global equities bounced around but ended the week with international stocks (+1.1% MXEA Index) outperforming domestic stocks (-0.4% S&P 500). It was, in fact, the second consecutive week of losses for the S&P 500, which has “crashed” to +11.3% year-to-date. Despite all the talk about growing inflation pressures and the Fed being behind the curve, the yield on U.S. Treasuries maturing in 10 years or more declined again. The 10-year bond is currently trading with a yield of ~1.61%, which is in the same zip code as the pre-pandemic yield. Often called “the smart money”, bond investors are not pricing in out-of-control inflation. For additional asset class return data, click here.
Should I Own Bitcoin? Bitcoin was in the news a lot last week, but not for the usual reasons. From last October through April of this year, the price of Bitcoin appreciated approximately 6x to nearly $65,000 per Bitcoin. The prices of other digital assets gained momentum as well, buoyed by growing institutional engagement as major banks, financial institutions, and electronic payment services announced cryptocurrency offerings and/or initiatives (there are more than ten Bitcoin ETFs awaiting approval from the SEC). It felt a bit like a digital asset land grab and the excitement was palpable. There were, and still are, skeptics of course. But bearish arguments were largely drowned out by the overwhelming euphoria as prices rose higher among an ever-broader landscape of digital assets.
The feel-good momentum in digital asset prices came to a screeching halt in the last two weeks. Cryptocurrency doubters and critics gained the upper hand as Bitcoin’s price fell to ~$30,000 at one point. There’s no single reason for the decline in Bitcoin’s price. Rather there were several contributing factors, including but certainly not limited to:
- Rumors that the U.S. Treasury is planning a crackdown on money laundering carried out through digital assets.
- Tesla’s CEO Elon Musk, once a Bitcoin cheerleader (Tesla purchased some $1.5 billion of Bitcoin in February), said Tesla would no longer accept Bitcoin as payment over climate concerns.
- China, which happens to be developing a government-run cryptocurrency, banned financial companies from providing services for crypto trading.
- Investors using leverage were forced to liquidate positions to meet margin calls as prices plummeted, adding downward pressure.
Amid a significant drawdown, should you buy Bitcoin now? While there is a large and growing number of digital assets and cryptocurrencies available to buy, in this piece I’m limiting the discussion to Bitcoin as this blog is designed to be read in five minutes, give or take. Moreover, Bitcoin is the most successful cryptocurrency to date, just about everyone has heard about it, and it has the “longest” trading history (which isn’t saying much since Bitcoin hit the market a little more than ten years ago).
In full disclosure, I made my first Bitcoin purchase in 2017. To be clear, it was a very small purchase, which at the time I viewed as an educational investment. I wanted to learn more about digital assets and blockchain technology – putting skin-in-the-game focused my attention. Having said that, this missive should not be interpreted as a comprehensive research report nor as an investment recommendation.
For enthusiasts, the investment premise for Bitcoin centers on its independence, ease of use, and limited supply characteristics. Bitcoin was invented in 2008 by an unknown individual or group of people using the name Satoshi Nakamoto. Nakamoto published a white paper in late 2008, describing a “…peer-to-peer version of electronic cash [that] would allow online payments to be sent directly from one party to another without going through a financial institution.”
Independence and frictionless transactions are useful, but scarcity is what proponents argue makes Bitcoin a legitimate “store of value”. The total supply is limited to 21 million Bitcoins, but Nakomoto didn’t release all of the Bitcoins at once. Instead, Bitcoins are computationally created through a process called “mining”. Mining requires enormous computing power to solve complex mathematical equations that verify transactions on the blockchain. You can think of the blockchain as a sophisticated, timestamped public database that no individual or group controls. Miners are incentivized to solve the equations through the award of new Bitcoins. The reward declines over time, thus limiting the number of new Bitcoins in circulation. Currently, there are approximately 18.6 million Bitcoins available, and it could take more than 100 years to mine the remaining 2.4 million coins—the combination of limited supply and issuance results in manufactured scarcity.
Supporters believe Bitcoin’s store of value makes it a viable alternative to fiat currencies (i.e., paper money), and many liken it to “digital gold”. Gold has a long history as a store of value as its supply is limited, making it a useful hedge against inflation (sometimes) and currency debasement. Moreover, in an era of seemingly endless central bank money printing, the ratio of gold reserves to global currencies has declined from 1:2 in 1970 to 1:10 today (source: Fidelity). Bitcoin has two advantages over gold. The first advantage is that while gold is rare, its supply is not finite like Bitcoin – approximately the same amount of gold is mined every year, adding to global supply. The second advantage is that because Bitcoin is entirely electronic, it’s easier to transact with Bitcoin than gold. Gold has a few important advantages over Bitcoin, including industrial uses, aesthetic appeal in jewelry, and of course, you can touch and hold gold. Even considering the long history of gold, Bitcoin proponents point out that Bitcoin is a viable competitor and undervalued. With a market capitalization of ~ $700 billion (as of May 24, 2021) compared to $11 trillion for gold, Bitcoin adherents believe there is a lot of potential price appreciation upside.
However, as a relatively new entrant to the store of value asset class, would-be Bitcoin investors must be prepared for extreme price volatility. Whether compared to equities or gold, Bitcoin’s volatility is next-level stuff. As the chart below highlights (click to enlarge), Bitcoin has experienced nine drawdowns of 40% or more in its short trading history, including three drawdowns over 80%.
Source: Visual Capitalist
To me, the most significant commercial value related to cryptocurrencies will be derived from the underlying blockchain technology. A blockchain is a decentralized database that no single person or group controls (the technical term is a “distributed ledger”). Unlike traditional databases, where data is structured in tables, a blockchain structures its data in limited-capacity blocks. When a block’s capacity is filled, it’s timestamped and linked to the previously filled block forming a “blockchain” of data. Notably, the computers powering the blockchain, called “nodes”, are independently owned and operated. In this way, if a user tampers with the data, all other nodes will cross-reference each other and pinpoint the node with bad information. This system forms an irreversible and transparent data timeline of events. For Bitcoin, the blockchain consists of every Bitcoin transaction made in history. But the broader use case for blockchain technology is that it will disrupt everything. By everything, I mean financial transactions, real estate title transfers, sharing of medical data, voting, monitoring supply chains, clearing and settling stock trades, copyright and royalty protection. Essentially, any activity that requires a physical intermediary.
Bitcoin and other cryptocurrencies are manifestations of their underlying blockchain technologies, and it’s not clear who the eventual winner, or winners, will be. Bitcoin may be just paving the way for a future digital currency. Similar to how the first web browser created in 1990 (“Archie Query Form” – ever heard of it?) sowed the seeds for the popular Google Chrome and Apple Safari browsers today.
Regardless of which cryptocurrency rises to the top, blockchain technology will fundamentally change our lives. If you don’t believe me, consider that Russia, China, Japan, and the U.S. are actively exploring issuing government-controlled digital currencies. If launched, these digital currencies will present competition for Bitcoin. Still, the fact that major central banks are exploring the concept legitimizes the use case for cryptocurrency and blockchain in general. It’s a brave new world. You don’t have to invest in blockchain technologies, but you won’t be able to avoid their impacts on your life.