Story by: Aaron Brown
The cryptocurrency market is one of booms and busts. Bitcoin went from essentially zero in 2009 to almost $150 by 2013. It then fell 60% and rebounded to $1,150. By 2015, it was down 85% to $175 (although still above the high in 2013). It then skyrocketed, peaking at more than $20,000 by the end of 2017. In 2018, it again lost 85% of its value to $3,200 (but still above the 2015 high). This year, Bitcoin rose to more than $9,000 and now hovers around $8,100.
If the pattern of the last two rallies repeats, Bitcoin could rise to $60,000 to $400,000 before crashing 85% again. But today’s cryptomarket is far different from the ones in 2013 and 2015, when the last two rallies started. It’s much larger for one thing, $260 billion in market cap compared with $1 billion in 2013 and $3 billion in 2015. There are far more cryptoassets and far more users. More than $30 billion of investment capital was spent in 2018 building platforms and code bases. The regulatory picture has clarified considerably, and big companies including JPMorgan Chase & Co. and Facebook Inc. are jumping into the sector. (Full disclosure: I own Bitcoin and other cryptocurrencies.)
Of course, that doesn’t eliminate the chance of bubble and crash. Even assets that don’t change, that are as boring as gold or residential real estate, have experienced booms and busts. With the rapid innovation, radical ideas and disruption of crypto, investors have to expect a lot of volatility. But is there a chance they could see a few years of sane returns, with drawdowns limited to, say, 20% instead of 85% or more?
One place to look for evidence is the Bitcoin options market. In late November 2017, when cryptocurrency prices were similar to those now, there was active trading in $10,000 one-month Bitcoin calls at implied volatility above 300%. That means paying $2,200 for the right to buy Bitcoin at $10,000 when it is selling for $8,000. Bitcoin has to go to $12,200, a more than 50% increase in a month, just to break even on this contract. Investors thought there was a 25% chance Bitcoin would go above $10,000 in December and, if it did, its expected price was almost $19,000. If it didn’t, its expected price was only about $4,000.
Today the contract sells for a more reasonable $200 at about 85% implied volatility. That suggests a 15% chance of Bitcoin going above $10,000 in a month and an expected price of only a little more than $11,000 if it does. If it doesn’t, the expected price is around $7,500. That’s a volatile investment, but nothing like 2017. So the probability of a bubble or crash in the near future seems smaller than the last time prices were near this level.
Another clue is correlation with the S&P 500 Index. Cryptocurrencies are technology businesses, which tend to have high correlation to the S&P 500 because they do well in good economic times with strong demand growth, support for innovation and inexpensive capital. But they are also substitutes for traditional finance and can do well when populists threaten trade wars, militarists threaten shooting wars or progressives talk about spending increases, wealth taxes and financial regulation.
The table below shows the average and standard deviation of the three-month return on Bitcoin, grouped by the correlation to the S&P 500 in the previous three months. These are quarterly returns, not annualized. You can see that when correlation is near zero for a quarter, Bitcoin average returns are very high the next quarter, but volatility is even higher. These are the boom and bust quarters. (A correlation of 1 implies that two variables move perfectly in the same direction, whereas a correlation of negative 1 implies that two variables move perfectly in the opposite direction.)
The chart above shows Bitcoin’s correlation with the S&P 500, which now stands near -0.2, a point where volatility has not been extreme in the past. Since mid-2018, the correlation stayed near zero only for a couple of months early in 2019. But during the bubble and crash at the end of 2017, correlations were near zero from September 2017 to January 2018. Generally speaking, Bitcoin seems to alternate between positive and negative correlations with the S&P 500, only occasionally spending time near zero, and those times seem to have the rapid price increases, presumably because the Bitcoin prices are not reflecting fundamentals.
Looking at the evidence, it appears the next cycle might be different. Whether that’s because the sector has matured or investors have become smarter, I couldn’t say. But my best guess is prices will swing this summer in response to fundamental news rather than screaming up on FOMO before crashing.by