Larry Berman's Educational Segment
Maybe, the answer is maybe. Last week I suggested that Crypto and Bitcoin was a Ponzi Scheme. The security regulators official definition can be found here. Let me rephrase. It’s not a Ponzi Scheme (per se), but it is worth only what the next person will pay for it! For me that is close enough!
But Larry, you can say that about any asset. Correct, but I know when a company (asset) has earnings (yield/dividends) and free cash flow, I can better determine what its (relative) value should be. Bitcoin is a simple economic model of price behavioural changes in demand relative to a limited supply. In theory, it could go up forever as long as there are more buyers than sellers. When you look at it from this lens, you get a little whiff (stench) of the more speculative asset class that it is versus “the uncorrelated hedge” that some (promoters) will have you believe. What happens to price when all the willing buyers are in? Ask yourself this question before you pull the #HODL trigger?
“According to the scarcity principle, the price for a scarce good should rise until an equilibrium is reached between supply and demand. However, this would result in the restricted exclusion of the good only to those who can afford it.”
Now let’s talk Nobel Prize winning portfolio construction. Fundamentally, you should be adding assets to your portfolio that help improve your risk-adjusted returns. That is, a higher return with a similar or lower level of volatility. I agree with this notion 100 per cent, as long as it is repeatable. The chart below shows that Bitcoin has historically had a very low correlation (sometimes positive and sometimes negative) with global equities.
This (in theory) makes it a very good asset to include in portfolios to help diversify you. You have (had) an asset historically that makes sense to include (boy don’t I look like a fool for missing it!). Now let’s look at the forward based part of the theory. Will it rise in the future at a faster rate than other assets (jewellery, wine, artwork, baseball cards, stamps, and of course equities) that one might have in their portfolio in addition to traditional equities and bonds. All collectables are speculative, but they tend to have utility (look good, taste good, feel good).
One could argue that crypto has a utility too (avoiding tax, evading law enforcement, money laundering, I’m sure there are other too I’ll hear about after this). Since COVID, the correlation (one year daily) has turned significantly higher and while it’s not perfectly correlated and so offers some diversification, the correlation is rapidly increasing. The benefits are eroding significantly. Many today are pointing to this proving/suggesting, that Bitcoin is little more than a speculative asset that is not a hedge against currency debasement or inflation. And if that is OK for you, then go for it, but understand what it is you are buying. That’s really my point here, I’m not sure that most really understand this. Just look at the fiscal duress President Nayib Bukele has brought to El Salvador.
The other aspect of the Nobel Prize winning portfolio construction is the look at volatility lens. This is far more behavioural than mathematical. Markowitz once remarked that while he invented this stuff, he does not like to see the value of his savings go down a lot. It’s the volatility lens that bitcoin fails at. The promoters will tell you that once it’s broadly adopted, volatility will fall. So too will price (see economic arguments above). Historically, the 30-day volatility (similar to the VIX) is two to three times that of the global equity market and closer to ten times that of fixed income. Do you really want this, and can you handle it? Most cannot, as the behavioural aspect of seeing your savings rise and fall is the driving factor for most.
So it comes down to the individual’s ability to handle the ride. For me, and for most, it’s not something that makes sense to include in your retirement portfolio due to the far more speculative nature. Bitcoin, Crypto, and NFT’s have been suggested to be more like artwork. It’s worth what the next person would pay for it and its beauty is in the eye of the beholder.
So the question is, should you have it in your portfolio? The answer is yes if you like volatility and uncertainty. The answer is no if you like stable income, cash flow you can reinvest, and a more predictable way to understand what it’s worth.
Digging a little deeper into the promoted speculative aspect of Crypto, we’ve reproduced some facts from a Bloomberg terminal story last week.
Some US$200 billion in crypto assets have blown up in the past week, led by the collapse of the so-called Stablecoin Terra USD. The crypto universe used to be small and dominated by Bitcoin enthusiasts, but it has swelled as investors sought higher returns amid negative real interest rates.
Hundreds of crypto currencies have been minted in a flurry of speculation. Anyone can create a virtual currency, market it to investors and use the money as he pleases. While fiat currencies such as the dollar are backed by governments, crypto currencies are backed by faith in their developers. What could go wrong?
Investors found out last week. Stablecoins are supposed to hold a fixed peg and let investors seamlessly trade crypto assets. Some are backed by fiat money, though their inventors don’t always disclose what’s in their reserves. Other stablecoins like Terra are underpinned by algorithms, sometimes linked to another crypto currency—in Terra’s case, the token Luna.
To drum up demand for its currency, Terra’s developers created a “decentralized lending” platform that offered interest rates of up to 20 per cent on deposits. Terra was supposed to hold a $1 value. We were also told before the 2008 financial panic that prime money-market funds wouldn’t break the buck. Then one did. Despite its supposedly fail-safe algorithm, Terra was backed by nothing more than market confidence. And we’ve learned time and again what happens when investors panic. As investors sold off crypto, Terra’s algorithm broke and its value plunged to 36 cents on Wednesday. What happens to Terra owners? Stay tuned.
One risk is that Terra’s rout causes investors to lose faith in other virtual currencies and creates a market contagion. Crypto currencies are often used as collateral for trading, and other popular tokens are getting pummeled this week. The stablecoin Tether, which is backed by opaque hard currency reserves, wavered from its dollar peg on Wednesday.
Shares of Coinbase, the crypto exchange that benefited from enormous market liquidity and lack of investor discipline, have also tumbled. Coinbase assures customers it is at “no risk of bankruptcy.” But on Tuesday it also disclosed that its customers would be unsecured creditors in the event of a bankruptcy, meaning their $256 billion in crypto and fiat currencies could be wiped out. Nice of Coinbase to tell us now.
Another danger is that the crypto turmoil bleeds into the banking system. Crypto enthusiasts claim that virtual currencies “disintermediate” financial institutions since you don’t need a bank or broker to make transactions. That’s true up to a point. But credit to buy crypto has to come from somewhere. Who’s standing behind it? Nobody knows.
The crypto market ballooned to $2.9 trillion last November from some $500 billion in November 2020. This runup wasn’t only driven by millennials gambling with stimulus checks. Central banks had made credit essentially free, which encouraged speculation.
The point is that there are always unexpected casualties when risk aversion returns with a vengeance. This is why junk bond prices are falling as concerns mount that some companies may struggle to roll over their debt, especially if the Federal Reserve’s tightening tips the country into a recession.
The European Central Bank recently warned banks to hold extra capital against leveraged loans, which are sensitive to interest rates, to cover potential losses. As rates rise, some could default. About $800 billion in leveraged loans in the U.S. were issued last year, 60 per cent more than in 2019. Regulators won’t know who’s overextended until markets shake out.
Debt covenants and market discipline were already deteriorating before the pandemic. When the economy shut down, the Fed was right to backstop financial markets. But it continued to provide support long after it was needed. As inflation heated up, the oracles of the Eccles building assured investors it was only “transitory” and monetary policy would remain supportive.
With inflation persisting and rising above 8 per cent, the Fed had no choice but to tighten. Some investors who were overextended may be wiped out, but this is what happens when the Fed keeps conditions too easy for too long and then has to stop abruptly.
Crypto currencies have passionate supporters, and the best may find a permanent place in the financial marketplace. But more than a few will wash out in this liquidity purge. As we learned in 2008, problems on Wall Street can quickly spread to Main Street. The challenge for regulators is to protect the financial system from damage that won’t end with crypto. They’d better be preparing for the next casualties.
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