Bitcoin: Bullish Fundamental Truths

I came across an extremely compelling argument for Bitcoin (Pending:COIN) (OTCQX:GBTC) this week as I was trying to backward-justify my decision to invest in cryptocurrencies for the first time. Perhaps I was magnetically drawn to the positive reinforcement I needed after watching my position get instantly crushed to the tune of double-digit percentage losses as cryptocurrencies embark on their most volatile month on record, but the argument rang true all the same.

The argument comes from the desk of Thomas Lee, a crypto bull who has a 2018 Ethereum price target of $1,900 (3x current value) and a 2018 Bitcoin price target of $25,000 (4x current value) as of December. In mid-January, in response to the onset of the crypto crush, Lee believed that returns would be more modest in 2018 but still strong, and that the $9,000 handle would be Bitcoin’s resistance point and that he “would be aggressive buyers around that level.” Lee also has a total crypto market cap target of $1.2 trillion (4x current levels) in 2018, as well as a 2022 Bitcoin price target of $125,000 (21x current value)

Lee is not, by the way, an overzealous kid throwing darts at the dartboard and investing in bitcoin as a get-rich-quick scheme. Before co-founding Fundstrat Global Advisors, an independent Wall Street research boutique that coincidentally is one of the only shops to give clients a price target on cryptocurrencies, he was chief equity strategist at J.P. Morgan (NYSE: JPM), an extremely senior seat in Wall Street’s #1 ranked (per the highly influential Institutional Investor rankings) research franchise. J.P. Morgan, of course, is also known for CEO Jamie Dimon’s extreme aversion to bitcoin, who once said, “If you’re stupid to buy it, you’ll pay the price for it one day.” Nevertheless, it doesn’t disqualify Lee’s sterling credentials to analyze bitcoin from a purely fundamental perspective.

One of the core lynchpins behind Lee’s extremely long thesis is the fact that cryptocurrency is to millennials as gold was to baby boomers, as a store of value. [Recall the fact that one of the central principles behind bitcoin is “artificial scarcity,” and the creation of bitcoin is rapidly decelerating as it nears its supply cap of 21 million coins]. Because millennials are just now entering their peak earnings years, Lee believes cryptocurrency has just now entered the first leg of its appreciation. Add this to the fact that institutional investors and crypto-focused funds have just recently arrived on the scene with their billions of dollars (aka, the adults with big money), and you’ve got a lot of potential demand for crypto that has not yet flowed into the markets.

With bitcoin, ethereum, and other cryptocurrencies entering into major bear market territory on the back of the upcoming Senate hearing and rumors of manipulated valuations through Tether, it’s a good time to refresh our views on crypto’s role in the markets and its potential as both a technology and an asset class through a fundamental view.

Looking at crypto through a fundamental lens

Now, I’ve been a crypto skeptic for the longest time. I refused to believe that something artificial could carry value. But then again I’m reminded that the value of any object or security is what the next person is willing to pay for it, and by that virtue the price of gold or of a share of Amazon (NASDAQ: AMZN), in theory, are bound to the same artificiality. The $1,300 you pay for an ounce of gold theoretically is the value you perceive for gold’s function as a store of value, or as an industrial metal used in electronics or jewelry; the $1,400 you pay for a share of Amazon represents the value you believe its future profits is worth to you. In the same vein, the $6,000 and $600 (for Bitcoin and Ethereum, respectively) you pay for the “gold” and “silver” of the crypto world, as Bitcoin and Ethereum are known, is the price you pay for these coins’ function as a store of value, as a transaction currency, and as an object of speculation (as gold and Amazon also are).

I purchased crypto – giving it a 5% portfolio allocation, and no more – on the premise that it would provide diversification to my portfolio. Indeed, though crypto and the S&P500 fell in tandem this week, some articles suggest that some of the fund outflows from equities found their way into crypto. Note that the ~10% the S&P500 has lost this week translates to roughly ~$2.4 trillion of value. If just 10% of this money found its way into crypto (as I’m sure it found its way into bonds, gold, and other haven assets), crypto’s total market cap would double overnight.

Smart hedge fund managers think outside of the box, and with the CBOE having opened Bitcoin futures trading and Goldman Sachs (NYSE: GS) as part-owner of a bitcoin trading desk called Circle Internet Financial, which transact in more than $2 billion of bitcoin per month, directing funds into crypto is now easier and more accepted for “big money” to do.

A lot of the analysis and articles you encounter on the internet surrounding crypto revolve exclusively around technical analysis: charts, resistance levels, the percentage that BTC or ETH is off its 7 and 30-day moving averages, etcetera. And while that information is useful in dealing with a volatile security, analysts like Lee remind us that beyond the technical mania that surrounds the coins, there is an underlying fundamental value to them. Add Bill Gates to the list of people who share this belief too – who are we to deny his understanding and evaluation of the technology?

Essentially, I see cryptocurrencies as having three fundamental components:

  • As a store of value;
  • As a transaction currency;
  • And as a speculation device, which is currently its primary use.

This is not radical thinking – in fact, a great deal of others have already written along these lines and many more already understand this – but often it gets lost in the noise of the crypto craze: after all, the technical-focused sensational headlines like “Bitcoin Breaks Below $10K Again – Next Stop $8K” probably gets more clickbait.

The first two uses of bitcoin – as a store of value and as a transaction currency – can readily be valued against gold and cash, respectively. I find that in trading crypto, it’s always useful to keep in the back of my mind what crypto’s current value is against these benchmarks, as a reality check. There are fools who gallantly claim Bitcoin will rise to $1 million per coin, implying a total possible bitcoin market cap of $21 trillion, about the market cap of the S&P 500 today. If we apply Bitcoin’s historical mix as ~33% of the total crypto market cap, that implies a total crypto market cap of $63 trillion – purely unrealistic and won’t happen.

In light of the recent crypto market crash, it’s useful to refresh our sense of crypto’s valuation against gold and cash, with the fundamental underlying belief that blockchain technology is a powerful, positive innovation that can drive efficiencies in our current financial system. Even Jamie Dimon concedes that point.

I’ll also add that bitcoin and ethereum (“digital gold” and “digital silver”) are probably the best crypto investments. With regulations hammering down on ICOs and smaller coins, and the general consolidation trends that give way to a handful of major players in any industry, the smaller altcoins will probably have a harder time climbing out of their rut and proving their value to the world when two larger coins with more perceived security and stability exist.

Store of value: crypto vs. gold

Gold, as most know, has been our default “store of value” for hundreds of years. It’s not the only store of value, of course – there are also an estimated 3-3.5 billion ounces of silver in the world, and at its current price of ~$17/oz, silver has a market cap of ~$50-$60 billion.

Gold dwarfs both silver and cryptocurrencies. In J. Christopher Giancarlo’s written testimony on the subject of cryptocurrencies (read the full testimony here from the Senate Banking website), published in advance of the high-profile February 6 hearing, he states the market cap of gold at $8 trillion. Even Giancarlo, in his testimony, acknowledges that gold’s market cap towers over crypto (which, at the time of writing, has just under $300 billion in market cap):

Perspective is critically important. As of the morning of February 5, the total value of all outstanding bitcoin was about $130 billion […] Because virtual currencies like Bitcoin are sometimes considered to be comparable to gold as an investment vehicle, it is important to recognize that the total value of all the gold in the world is estimated by the World Gold Council to be about $8 trillion which continues to dwarf the virtual currency market size.”

– J. Christopher Giancarlo, Chairman of the Commodity Futures Trading Commission

At a current price for Bitcoin and Ethereum of $6,000 and $600, respectively (values have plunged since Giancarlo’s remarks were released, though the two events aren’t directly correlated), their respective market caps are as follows:

  • Bitcoin: $102 billion (1.3% of gold)
  • Ethereum: $58 billion (0.7% of gold)
  • All cryptocurrencies together: $283 billion (3.5% of gold)

When Giancarlo says “dwarfs,” he really means it. I had thought of assembling a bar chart to illustrate the point, but the crypto bars were so small next to gold that they were impossible to see.

Of course, fundamental thinking must also recognize that there are clear differences in the utility of gold versus crypto as a store of value, both pros and cons. Right now, the largest con of using cryptocurrency as a store of value is directly because of the third usage of bitcoin I outlined above – as a speculation device. Right now, it’s almost impossible to think of cryptocurrencies as a store of value because its value is up and down double digits every day – not exactly the kind of asset you can use as a hedge against inflation.

But as crypto valuations undergo the price discovery process and eventually stabilize in the next few years, we must also realize that there are inherent benefits to crypto. Versus physical gold, crypto doesn’t need to be stored in a safety deposit box; versus paper gold, crypto doesn’t charge the (albeit small at a 0.40% annual expense ratio) fees that securities like GLD charge.

Crypto is also more easily bartered and used as an exchange currency than gold – imagine handing over a hundred bars of gold in exchange for a house, instead of simply transferring bitcoin – which you can now do in Saudi Arabia and in certain parts of the U.S. This forms the basis of the next valuation of bitcoin as an exchange currency.

Exchange currency: crypto vs. cash

It’s become a common headline that the U.S. is rather backward when it comes to paying for things with cash and credit cards. In China, where services like AliPay and WePay have become the norm rather than the exception, most people pay merchants as well as perform P2P transactions via a digital service.

Perhaps it’s not a surprise, then, that China (and Asia as a whole) is one of the crypto market’s biggest drivers – they have a higher perception of bitcoin’s fundamental utility than we do, because they more accustomed to using digital-based tools to handle everyday monetary transactions.

A recent article made a very astute comparison of the value of crypto versus the major measures of money in the world, including cash. The total value of the world’s currency and banknotes is $7.6 trillion (estimate current as of October 2017, though the volume of currency doesn’t move quite as quickly as other assets), roughly similar to the market cap of gold.

Let’s bring out the market cap comparisons again:

  • Bitcoin: $102 billion (1.3% of cash)
  • Ethereum: $58 billion (0.8% of cash)
  • All cryptocurrencies together: $283 billion (3.7% of cash)

Again, a very small portion of the world total of fiat currency. If we expand the definition of “fiat currency” beyond coins and banknotes and into bank deposits (known in Econ 101 textbooks as “M1”), we get a total currency cap of $36.8 trillion; if we add “near cash” such as savings accounts and time deposits (“M2”), the total becomes $90.4 trillion.

Crypto as a whole, relative to this total, becomes so small it would be a blip in a pie chart.

Key takeaways

The simple points made in this article are neither new nor radical – they are simply often overlooked in favor of sensational headlines. This article’s primary goal is to present the fact that there are fundamental (if basic) ways of looking at cryptocurrency valuations, as well as fundamental thinkers (such as Lee and Gates) who base their bullish opinions on rational exercises such as these.

New technologies, obviously, have a long adoption curve. The first PC was invented in the mid-70s, but didn’t see massive adoption and become a common feature of every household until the late 80s and 90s. Likewise, crypto’s fundamental uses as a store of value and as a means of exchange will take time to work themselves into the fabric of our lives.

Lee’s year-end 2018 market cap target of $1.2 trillion for the whole crypto market might sound like a daunting figure – but really, it’s only 15% of the market cap of gold, 16% of cash, 3% of M1, and 1.3% of M2.

Cash, for example, is 8.3% of M2. Imagine if crypto (which, in some people’s opinion, is superior because it’s more difficult to lose or steal) could overtake just half of this mix, or 4.1% – it would have a total market cap of $3.7 trillion, more than ten times its current value. The adoption curve may be slow, but it is trending in the right direction as bitcoin and ethereum gradually shed their speculative qualities and become the “blue chips” of the crypto world.

Disclosure: I am/we are long GBTC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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