The Capital
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The Capital

Psychology of a Crypto Bear Market

Prices might decline, but value is not transient: market sentiment remains optimistic, particularly among builders.

Statue of girl facing Wall Street bull on street.
Photo by Daniel Lloyd Blunk-Fernández

Supply-side Shocks and Bear Markets

Anyone can see that the market is down, including many crypto assets. But that’s not surprising — the United States, and the world at large, are facing a wide array of crises and recessions are generally inevitable.

The question is not if, but when and how bad. Recessions can lead to the reallocation of capital from less to more productive places, but others can lead to havoc if there was a build-up of exposure to unintended risk.

The U.S. especially struggled because of a shortage in supply: a shortage of workers, a shortage of energy, and a shortage of raw materials, just to name a few. Admittedly, many economists have studied demand-driven recessions and believe that they are the primary threat to growth.

But, supply-side shocks can have profound effects by not only undercutting a country’s ability to produce the usual goods and services, but also driving inflation as wages cannot realistically expand enough to cover the growth in nominal price levels. Inflation is particularly harmful because it affects everyone — not just particular asset holders.

Some of my prior research found that higher gasoline prices, for example, reduce consumer sentiment. My research has also found that lower levels of consumer sentiment also lead to substantial declines in consumption.

These might not seem like groundbreaking insights, but it’s surprisingly difficult to publish even basic truths in academia right now. And some academics have even argued the opposite: that shifts in sentiment do not correspond to shifts in consumption.

But for all intents and purposes, let’s go with the hypothesis that sentiment does matter because it influences the psychology behind buying, selling, and investing. When you expect the future to be bright, you’re more willing to take risks — it’s just human nature.

When you’re in a bull market, the psychology is more about momentum trading: what are people talking about and what is building momentum? But during a bear market, the psychology is about building long-term value that is going to sustain well-beyond the current cycle.

Measuring Sentiment

That begs the question: how do we learn about the long term value of an asset? Much of the answer requires delving into detail about the project, the team, and so on. But there’s also information contained in measures of sentiment — that is, perceptions of current economic activity and expectations about future economic activity.

Expectations are what drives investment in both human and physical capital, so they are meaningful indicators. And, just like we hear about consumer sentiment, we can also measure the news sentiment of cryptocurrencies. There are many ways to produce such measures, but I’m lucky to work with data from Refinitiv, which uses a model from MarketPsych.

They produce a measure of sentiment — or an index that hovers above and below zero — for each day and across asset classes. The index is constructed by feeding every news article and social media through their natural language processing (NLP) algorithms, tagging words and phrases as high or low sentiment. They also disaggregate across different types of sentiment, including trust, uncertainty, urgency, and more.

That’s especially useful for understanding the latest crypto trends and how people are reacting to different crypto assets across the world.

Latest Data on Crypto Sentiment

Consider the figure below for a measure of news sentiment about Bitcoin, Ethereum, and Solana. Even though there’s been a dip in BTC and ETH, each have been improving, relative to their fall in May and June, and Solana has improving more than others. Solana has also had more volatility than others.

Author’s calculations from Refinitiv: news and social sentiment

Next, we can also explore the degree of optimism for each of them. Solana has much greater volatility than either Bitcoin or Ethereum, but all three have hovered close to 0.05 since May and have climbed more recently. (In separate analyses, Solana actually has a strong forecast for price growth.)

This plot from Refinitiv shows optimism for BTC, ETH, and SOL.
Author’s calculations from Refinitiv: news and social optimism

These sentiment indices are admittedly useful for understanding short-term fluctuations, but they can also reveal important features about the market as a whole. Despite the drop in crypto coin prices, there is not only still optimism and positive sentiment about crypto assets but also a revival of them.

Expectations and Speculation

Many critics argue that crypto assets are speculative. Surely, we could have a philosophical discussion about what’s more speculative: a fiat currency that relies on centralized institutions coordinating an imaginary money supply or decentralized actors coordinating on a resilient technology stack.

But, the question still stands for any asset: when do expectations turn speculative? Expectations contain both private and public information, so speculation takes place when an investor believes that an asset will appreciate without having the evidence to substantiate that belief.

Interestingly, the Refinitiv data contains an index that reflects the degree of emotion versus fact, which can be further partitioned between news articles and social media. Below, let’s examine the price of Bitcoin, paired with sentiment about emotion versus fact.

Focusing on May to the present, the price has fallen a lot faster than the news or social media index of emotion versus fact. That’s important: if speculation was driving the price of Bitcoin, then factual sentiment should fall fast and pull down the ratio — that’s not what we see. Moreover, we see emotion versus fact on a slight downward trajectory as the price declines.

This plot from Refinitiv shows the emotion versus fact sentiment for Bitcoin, and the price of Bitcoin.
Author’s calculations from Refinitiv: BTC news and social emotion vs. fact

That’s not just for Bitcoin — the same pattern holds for Ethereum: the price fell recently, but the emotion versus fact ratio has not fallen with it.

This plot from Refinitiv shows the emotion versus fact sentiment for Ethereum, and the price of Ethereum.
Author’s calculations from Refinitiv: ETH news and social emotion vs. fact

There will always be some speculation, but what we’re seeing in the crypto market is more a function of a ripple effect from other asset markets, coupled with a reallocation of capital from projects that may have had momentum, but little substance or follow-through behind them (e.g., Terra).

Bear markets might seem challenging, but for serious investors, they are times to build long-run wealth. Stars are never made in the good times — it’s in the tough times when we distinguish ourselves and grow. The same holds for investing, so let’s use the time wisely.

This article was written by Christos A. Makridis, the Chief Technology Officer and Head of Research at Living Opera. He is also a research affiliate at Stanford University’s Digital Economy Lab and Columbia Business School’s Chazen Institute, and holds dual doctorates in economics and management science & engineering from Stanford University. Follow us at @living_opera!

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