How to Use Relative Valuation for Cryptocurrencies
Lesson J: From Bitcoin to Being a Crypto Maxi
Similar to absolute valuation, we find that because cryptocurrencies are not assets that generate their own cash flow, we cannot rely on traditional methods to arrive at a relative valuation. This makes intra- and inter-relative values difficult to determine. With traditional assets, we can compare P/E ratios between different years for the same asset or P/E ratios between different assets.
But for cryptos?
Answer: There is a somewhat creative way around this. It involves reconceiving what “relative” means given certain circumstances.
Defining “Relative” for Crypto Valuation
At the time of writing (mid Jan 2023), there are two distinct limitations of the cryptocurrency market.
One limitation is that the market is still correlated strongly with the macroeconomy and traditional financial markets. Even though one of the original intentions was to be decoupled from traditional finance, the crypto market is comparatively small. The entire cryptocurrency market is estimated to be about $1.6B, while in comparison Apple is estimated to be around $2T in 2021.
The cryptocurrency market therefore relies heavily on liquidity from traditional financial sources; and paradoxically, as crypto becomes more established, traditional investors and institutions look to have a piece of the action — including the likes of Goldman Sachs, Morgan Stanley, Black Rock, and BNY Mellon.
A second limitation is that the size of the crypto market means that most crypto projects and platforms are interlinked through borrowing and lending. We see the repercussions of this when a major platform or lending protocol goes bust and creates a cascading effect of defaults and collapses.
What do these limitations mean with respect to the relative valuation of crypto?
If relative valuation involves the comparison of like assets, then in one sense no matter how distinct a crypto project might be from another, they will all tend to follow the lead of the most dominant coin.
Bitcoin presently holds about 39% of the crypto market in terms of total value. It’s been decreasing with the platform dominance of Ethereum, which holds 19% of the market. But these percentages can be somewhat deceiving since Ethereum is a utility mainnet which dominates the crypto space in terms of hosting a myriad of applications. Bitcoin, in contrast, is merely a currency — though efforts are being made to create a Bitcoin utility platform.
The upshot: If we take the crypto market to be a web of relative relations influenced by one or two major coins, then we can look to either Bitcoin or Ethereum as relative indicators as to how the value of a cryptocurrency might perform.
Before Ethereum’s Rise
But before the shift towards Ethereum started, the conventional wisdom with regard to relative valuation was simply to follow Bitcoin. So if it started to rise in price, you could wager that many of the alt coins would follow. Furthermore, if gains in Bitcoin were too small then riskier alt coins might gain more momentum.
As a result, one investment position based upon relative value to Bitcoin is to hedge against the direction Bitcoin might go. Futures trader M.C. Ross explains:
“Relative value trading is always trading with a hedge. For example, buy bitcoins, and sell an equivalent amount of Ripple against those bitcoins. This will allow you to make money should the price of BTC lower. Relative value trading always has two open positions (btc/usd & xrp/usd). We call these positions ‘legs’, and it gives the trader greater flexibility within his trading compared to outright trading.”
While the cryptocurrency market expanded in the number of coins in 2021, the crypto winter in 2022 and the subsequent crashes of major platforms and lending protocols should see that number decrease over time. According to Josh Howarth, although there were 21,844 cryptocurrencies in existence (as of Nov 2022), only 9,314 seemed to be circulating and trading.
After Ethereum’s Rise
Sebastian Purcell covers in more detail why he thinks Bitcoin experienced its zenith of dominance in 2017 and is now on its descending arc as Ethereum gains ascending momentum. In 2021, Purcell notes the correlation between Bitcoin and Ethereum dropped significantly, with Ethereum decoupling from Bitcoin (0.68 correlation). That figure has risen during the crypto winter of 2022-? to 0.88, probaby due to the state of the macroeconomy (when things get bearish, crypto value tends to gravitate more towards Bitcoin).
But this movement actually fits within Purcell’s larger narrative. This narrative is entitled “Crypto Maxi”, which follows the general observation that when the market is experiencing a decline, Bitcoin outperforms Ethereum. Yet when the market improves, Ethereum will gain momentum on Bitcoin and in fact outperform it. What is key for this strategy is determining when the turning point is about to occur, and thus when to get into Bitcoin (and out of Ethereum) or out of Bitcoin (and into Ethereum). Suffice it to say, Purcell’s subscription services provide access to this information via his algorithmic trading schema.
What Does this Mean for Relative Valuation and Cryptos?
In sum, according to Purcell there are two key components that unlock relative valuation for cryptos.
- For relative comparison, everything gravitates to comparison with Bitcoin and Ethereum.
- How each performs depends on larger macroeconomic conditions.
Let’s unpack these points.
For the relative valuation of cryptocurrencies, point 1 is extremely significant since it means you can devise a system in which the performance of cryptocurrencies can be compared relative to lead indicators — i.e. Bitcoin and Ethereum performances.
It is important to note that in lieu of price-to-earnings and cash flow analysis, this method relies on price momentum, which in turn is determined by the larger macroeconomic factors (point 2) affecting the crypto market. In other words, if we’re following the correlated relation between Bitcoin and Ethereum, we have to bear in mind the larger correlation between the crypto market and the macroeconomy.
Let’s see this in practice.
At the time of writing, the traditional markets were experiencing a small rally due to news affecting the Fed’s position on interest rate hikes. As a result, there was a small crypto rally. This means you can expect Ethereum to be the lead indicator. In the image below, this is represented by the purple slice of the pie chart. The chart shows what the algorithm is holding: 10% in ETH and 90% in cash or stablecoin.
Several days later, here’s the ripple effect on other coins:
A lot more coins riding the wave led by Ethereum!
The other information columns (left and center) indicate the relative value of other cryptocurrencies in relation to Bitcoin. Do they have momentum on Bitcoin? Are they beating Bitcoin if they do?
(Paid Art of the Bubble subscribers get access to daily updates on these questions.)
Does this relative valuation strategy work?
In short, yes. Purcell notes that when looking at a time slice between Jan 2018 to July 2022, you can see that despite some ups and downs, the gain resulted in 100x. Whereas simply HODLing your Bitcoin only returned 94%.
How This Can Be Applied
There’s nothing like a dry trial run. You can actually follow the Bitcoin market to see how other cryptos do in comparison. More advanced comparative analyses and tools are available on sites like Trading View.
Or, if you are really lazy, try out a subscription to one of The Art of the Bubble’s membership levels to get reports and charts that cover such most things crypto.
This article is a part of the Crypto Industry Essentials educational program presented by The Art of the Bubble.
Though this article is credited to me, it contains some written material by Sebastian Purcell, PhD from his The Art of the Bubble education series on cryptocurrencies.
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