About 18 months ago, we wrote an article titled “Do Cryptoassets Deserve a Place in Your Portfolio? The Case or Digital Assets as an Asset Class” exploring the textbook features of an “asset class” and concluded that “digital assets offer a differentiated risk-reward profile from more traditional asset classes…there’s a compelling case for readers to consider an allocation to cryptoassets in their own portfolios.”
Against the backdrop of the COVID-19 pandemic and the resulting turmoil in global economies and financial markets, we wanted to update whether our initial research still holds and whether the fundamental investment case for Bitcoin, and cryptoassets more broadly, remains compelling.
If you’re asking a classic institutional investor what keeps them from investing in Bitcoin and other digital assets, they’d often cite the lack of a consensus valuation framework, the high levels of volatility, and concerns about potential correlation with more traditional investments.
1) The Lack of a Consensus Valuation Framework
In contrast to discounted cash flows with financial projects and equities comparable property analysis in real estate, there’s still no consensus on the best way to conceptualize the underlying value of different cryptoassets. That said, there are several strong contenders that value-focused investors may want to consider in concert.
One valuation framework that has garnered plenty of attention ahead of Bitcoin’s highly-anticipated, once-every-four-year “halving” of miner rewards is the so-called stock-to-flow (S2F) model. Perhaps the most basic of the valuation methods, the S2F model treats Bitcoin like other “store of value” commodities like gold, silver, and platinum, whose value comes from their relative scarcity. By comparing the current supply against the flow of new supply added, we can get an objective measure of how “hard” and scarce different assets are, and by extension, a potential target price:
While the S2F model has proven to be fairly accurate to date, it does give potentially overly bullish valuation levels, such as a single Bitcoin being “worth” about $1,000,000 in about five years, at which point Bitcoin alone would be worth about half of the current value of the US stock market, the world’s largest.
Perhaps a more traditional economic valuation model is the MV=PQ framework. In the words of author and venture capitalist Chris Burniske, “A cryptoasset valuation is largely comprised of solving for M, where M = PQ / V. M is the size of the monetary base necessary to support a cryptoeconomy of size PQ, at velocity V.” In other words, to value any digital asset, an investor just needs to project the size of its annualized total addressable market (PQ) and divide by how frequently that asset changes hands (V).
In a classic example, we could estimate that the total market for remittances is $500B/yr, that Bitcoin could/would/should eventually be used for 50% of the market, and that Bitcoin’s velocity for that purpose runs at 5 (buy/sells per year). In that case, the remittance market alone might be worth 50% * $500B / 5 = $50B in market cap; investors would then add on additional methods of utilizing Bitcoin, such as for investment purposes as a store of value, for illicit purchases, etc. Though seemingly ground in logical economic relationships, the uncertainty with estimating so many inputs can lead make it difficult to home in on a precise valuation using the PV=MQ equation.
Finally, market-derived valuation models can help quantify and adjust for investor sentiment. Like a classic price-to-earnings ratio in the stock market, the Network-Value-to-Transactions (NVT) ratio simply calculates the value of the network as a multiple of its daily (on-chain) transaction volume. As the chart below shows, Bitcoin usually trades in an NVT range between 40 and 80:
When the NVT ratio approaches the lower end of its range, it suggests that the value of the entire digital asset is trading at a historically low level relative to its usage, whereas a high ratio shows possible overvaluation relative to the fundamental underlying usage of the network. Unfortunately, more and more volume is moving “off-chain” so analysts may have to make adjustments to the classic NVT ratio to accurately determine value moving forward.
Finally, traders can use purely price-based method to estimate value like the Mayer Multiple. It completely ignores underlying fundamental utility, but comparing the price to its own 200-day moving average has historically helped identify periods when Bitcoin was poised to outperform (when price was < 0.5X its 200-day MA) and underperform (when price was > 2.4X its 200-day MA):
Source: TradingView, Blakeley
By using a combination of these valuation tools and acknowledging their individual shortcomings, traders can derive an estimate of the potential reward for buying cryptoassets like Bitcoin at any given time.
2) Volatility Gradually Falling
Of course, even with an estimate of potential reward, a professional portfolio manager must keep risk management at the top of their mind. For better or worse, volatility (specifically covariance, which is a combination of raw volatility and correlation) is used as a proxy for risk in finance…and when it comes to Bitcoin and other cryptoassets, volatility continues to run persistently higher than other traditional assets.
The chart below shows the trailing 1-year volatility as a percentage of price on a log scale:
Source: WooBull, Blakeley
As you can see, Bitcoin’s volatility has generally trended lower over the last decade, though it remains generally higher than many of the more mature asset classes. That said, after the recent turmoil in the oil market, Bitcoin has actually been less volatile than one of the planet’s fundamental commodities.
Moving forward, continued adoption and financialization (allowing investors to manage their risks through derivatives) should continue to push down Bitcoin’s volatility in the years to come. In a potential self-fulfilling prophecy, falling volatility could strength the case for Bitcoin as a “store of value” asset, providing support against rapid drops and driving down volatility further. Even if Bitcoin’s volatility remains elevated compared to more traditional investments, investors may still feel comfortable allocating a smaller percentage of their assets to it if the perceived future returns are strong enough.
3) Revisiting Bitcoin’s Correlation with Other Assets
Putting aside regulatory and logistical concerns, the last major hurdle preventing professional investors from allocating to Bitcoin are questions about cross-asset correlations. As the stylized chart below shows, the narratives driving Bitcoin have evolved over the years to include “uncorrelated financial asset” as a major theme:
Source: Visions of Bitcoin
However, as we saw during the peak COVID-19 financial panic in mid-March, the correlation between all liquid financial assets surged toward 1.00, with global stocks, bonds, gold, oil, and yes, even Bitcoin selling off in unison. If Bitcoin is strongly correlated with other financial assets during a market crisis, the exact time when investors need differentiated performance, it would be a far less compelling addition to a portfolio.
Thankfully, the longer-term evidence suggests that the recent period of strong positive correlation between Bitcoin and risk assets was likely temporary, driven by a mad dash for US dollars after an unprecedented deflationary shock to the global economy. As the chart below shows, the yearly correlation (using end-of-day closes) between Bitcoin and the S&P 500 has oscillated between 0.15 and – 0.15 over the past half-decade:
Source: Coin Metrics, Finnhub
Since markets have stabilized over the last month, the correlation has already started to edge lower.
In other words, the March spike in correlation between Bitcoin and other markets was driven by idiosyncratic factors, and even then, the long-term relationship between Bitcoin and the S&P 500 remains near zero, suggesting that Bitcoin remains a potentially attractive uncorrelated asset to add to a portfolio. Indeed, in a different kind of future crisis where supply shocks and inflation are more likely, it would be logical for Bitcoin to see its correlation to more inflation-sensitive investments like bonds and certain stock sectors fall to record negative levels.
In conclusion, advancements in valuation methodologies, the general trend toward lower volatility, and Bitcoin’s long-term lack of correlation with other assets make it a more compelling addition to a diversified, long-term investment portfolio than ever before. In the coming weeks, we will take a closer look at the fundamental drivers of cryptoasset value, as well as the impact that the introduction of futures contracts and other derivatives have had on Bitcoin’s price.