November was the ninth negative performance month for the year with the sector now trading over 80% lower year-to-date. In market conditions like this the two key questions in our opinion are:
- Have we reached the bottom yet; and
- What are the potential catalysts that could materially change sentiment.
We have discussed these two questions and others with investors and partners over the last month or so and the below is a summary of our key observations and conclusions.
The key thematics we see currently playing out in the market:
- Broad-based sell-off that is asset-agnostic as sector correlations increase — bitcoin has increased its sector dominance given relative liquidity and its role as the key trading pair for many alt-coins with no direct USD route
- The $250m+ monthly issuance through mining rewards continues to weigh on this market where incremental buyers are hard to find — falling mining profitability, and the impact this may have on security longer-term, is now also a key issue impacting sentiment
- Bitcoin Cash war was a significant distraction — forks are not a positive for the sector and neither was the unprofessional behaviour of the high-profile players in this drama
- Retail sentiment reaching new lows and market weakness (and regulatory oversight) has seen a material slow-down in ICO activity
Each of these is discussed in more detail below.
Broad-based selloff, bitcoin’s dominance continues to grow
After the market peak in early-January 2018, the sector has now lost around 86% of its value. After a period of falling volatility through the second and third quarter, bitcoin volatility has “normalised” back to around its longer-term average (and materially above almost all other asset classes):
Given ongoing regulatory uncertainty, the still immature nature of the tech (and market), we believe significant levels of volatility are here for at least the medium-term. We continue to see volatility as a “turn-off” for new potential investors (whilst attractive to traders). It materially increases investor risks (and therefore the return hurdles they demand) and highlights the immaturity of the sector.
The selloff has been broad-based with correlations rising from their early-January lows with alt-coins again “re-coupling” to bitcoin and correlations rising to their current, medium-term highs — as the chart below illustrates:
Whilst its somewhat of a hollow-victory (bitcoin is around 75% lower YTD), bitcoin has outperformed the sector — we believe bitcoin continues to be seen as the “safest harbour” in a highly volatile sea and also benefits from the buying created as investors exit alt-coins that do not have USD pairs. This has seen bitcoin’s dominance continue to grow through the middle and later part of the year and currently sees it trading around the year’s high:
Mining Issuance Continues to Weigh on the Sector
Monthly issuance of c.$245m into a market struggling to find the incremental buyer is a significant overhang and will continue to be so. The significant fall in asset prices has also materially reduced mining profitability which is leading to sector rationalization. Whilst the mining cost curve provides some valuation benchmark, like in commodities (see upcoming post), we believe it is possible to see prices stay below production costs for extended periods. From a network security perspective the falls in bitcoin’s hash power, to date, have had only a minimal impact (on a longer-term view) and hash power remains significantly higher than it was only six months ago (when bitcoin was at materially higher prices)
However, the implications of rationalising mining pools in terms of network security, the increased potential for network “attacks” and how it plays out through longer term incentive structures remains a significant talking point amongst market participants and the press.
Bitcoin Cash War — Significant Distraction/Overhang
A forced hard fork in bitcoin cash saw two sides battling over hash power with the “drama” bleeding into the bitcoin market. The increasingly vitriolic war saw increasingly threatening posturing. With key players discussing selling bitcoin to fund the potential costs of supporting their various fork, a new and unwelcome perceived overhang was added to the market. After an initial surge in hash power for both forks, largely posturing with hindsight, hashpower has fallen away and now, combined, both chains are below the pre-fork levels of bitcoin cash:
The war created an unwarranted and unwelcome distraction and did the asset class no favours in terms of positioning it as a credible disruptor to the traditional financial system. The final outcome, if there will be one, is not yet known although the current combined value of the fork has not protected bitcoin cash holders from the market selloff.
Whilst it was unhelpful we dont believe this was a key catalyst for the market sell-off but it clearly wasn't helpful into a market with already very weak sentiment levels.
Sentiment Reaching New Lows — If Not Already There, Must be Very Close to Capitulation
Retail turnover remains weak as demonstrated by volumes on major retail exchanges with trading levels reaching new YTD lows:
Sentiment has also turned 180 degrees — whilst Google searches containing “bitcoin” have risen modestly (historically a good predictor of price) unfortunately they are partly driven by searches of “is bitcoin dead” — an indication of where sentiment has fallen to.
Partly led by the absence of any material retail demand but also given the weaker broader market and valuations, ICO volumes have fallen materially over the last two months yet still stay at material levels with a longer-term view. Like witnessed over many equity market cycles, we would expect ICO levels to remain subdued until the broader digital asset market has stabilised.
Outlook and Potential Catalysts
All indicators — long/short ratios, retail turnover, mass media newsflow, trading patterns, social media “I told you so’s”, project clean-outs, regulatory interventions — point to extreme levels of bearish sentiment and suggests the incremental “seller” is near exhaustion. We expect volatility to remain inflated and it takes time to recover from a fall of this magnitude but any tangible catalyst into this market will see a significant change in the market’s current trading level.
So what are the potential catalysts that could turn sentiment and materially change the current demand/supply dynamics? What can help the market find the incremental buyer? We raise five potential catalysts below — of varying likely timing/probabilities:
- Valuation floor becomes too compelling — many projects now trading well below even asset backing and like all markets this one will find a level where the upside/downside asymmetry is just too compelling — most likely catalyst in the short/medium term and will be driven by alternative buyers first (i.e. traditional hedge funds/family offices/HNW)
- ETF approval for an established US exchange — simplification of ownership and storage that an ETF delivers to “mainstreet” investors likely to deliver significant incremental buyers over time –likely to happen but over medium/longer-term given short-term regulatory headwinds — Bakkt will also be a positive here
- Significant global financial instability — dislocation in the traditional markets has the potential to drive investors to decentralized stores of wealth (as we have seen in other economies under extreme stress) — signs of this happening in financial markets continue to build but in our view, bitcoin, as opposed to alt-coins, likely to be the key beneficiary of this potential re-rating
- Bitcoin block reward halving — bitcoin’s block reward halves in mid-2020 — historically bitcoin has performed very strongly into and after rewards are halved as demand adapts to the lower inflation environment — likely to support prices but will grow in importance mid/late-2019
- Central Bank adoption — any central bank adoption of bitcoin as a reserve currency would materially change the supply/demand dynamic — always a potential event but in our opinion still some way off, at best, and likely to only be a emerging/smaller entity at first
Whilst sentiment and market moves become overwhelming to market players, thankfully entrepreneurs and coders are doing what they do best and continuing to build and innovate. As the chart below shows, github activity remains high and generally unchanged by the distractions of market sentiment:
We remain steadfast that blockchain technology will disrupt whole swathes of the existing financial system and the significant upside for the chains, and business models that get it right, remains intact. The internet boom, bust and subsequent almost two-decade rally is the most pertinent precedent in our opinion. As a sign of the returns available from disruptive technology we put together a $100,000 “model portfolio” — investing $90,000 in the doomed Pets.com IPO and $10,000 in Amazon on the same day. As the chart shows below, even with this very poor asset allocation, the returns from a successful disruptor as only a small percentage of a portfolio more than made up for the short term losses and sees the portfolio outperform the S&P500: