Even if the worst is over, we don’t know if there will be a quick recovery. Remember that after the 50% crash from April to July 2021, prices quickly recovered to a new high, but after the crash that began in December 2017, it took more than two years for prices to rise in a sustained way.
Calculating a fundamental value for crypto is impossible as there are too many essential unknowns. However, we can try to compare cryptocurrencies to other assets to see if it appears to be undervalued or overvalued in a relative based on a historical basis. I will only look at Bitcoin, because it is the liquid of digital currencies and has long served as a benchmark for much of the crypto market. (I own Bitcoin and other crypto assets).
An important component of Bitcoin is a leveraged investment in technology. The same forces that drive profits in technology companies in general drive the financial success of cryptocurrencies, though not necessarily their fundamental utility, which is something quite different. Crypto projects are certainly riskier than most tech stocks and less capitalized.
Bitcoin is also correlated to the price of gold. It is often assumed that the correlation should be positive, since both gold and Bitcoin can be used to store value without being affected by inflation and other currency problems and can be more easily transferred than dollars when sanctions are an issue. In reality, there is a strong negative correlation when other factors are adjusted. Gold and Bitcoin are opposite solutions to lack of faith in currency. Gold is simple and tangible, backed by thousands of years of history and no theory. Bitcoin is complex and abstract, backed by 14 years of extreme volatility, with a grand theory. Gold does not require infrastructure; Bitcoin requires a huge world infrastructure.
Bitcoin has also historically benefited from volatility in both tech stocks and Bitcoin itself. It’s not that investors like volatility and drive prices up as a result, it’s that innovation requires volatility to thrive.
Four factors to represent Bitcoin prices explain 88% of the price variation in the last four years, as shown in the chart below. The proxy wallet that matches one Bitcoin today consists of, in round numbers, $82,000 of the Nasdaq 100 technology index, with $21,000 of borrowed money and $50,000 of borrowed gold. So the value of that proxy today is $11,000, but we add $8,000 for the current level of the Nasdaq index and $6,000 for the value of the volatility of Bitcoin, to get $25,000, versus a current market price of Bitcoin. approximately $20,000.(1)
Before discussing what the proxy wallet means, consider the table. It shows that the proxy wallet has done a decent job of tracking Bitcoin prices since 2018. The only major discrepancy is the March 2021 boom, quickly followed by a crash, but leaving Bitcoin in line with historical price relationships. .
Remember that I am not talking about core value. Bitcoin may be worth twice the proxy wallet, or half, or 10 times, or nothing. All we know is that current Bitcoin prices are 20% below their historical relationship to other market prices. If you think that Bitcoin was valued correctly on average for the last four years, then it is cheap today.
It is easy to understand the $82,000 in the Nasdaq portfolio, buying a Bitcoin is like putting $82,000 in technology stocks. If those stocks go up 10%, Bitcoin should rise $8,200. If those shares drop 10%, Bitcoin should lose $8,200.
Borrowing $21,000 in cash and $50,000 in gold is also straightforward. Bitcoin is statistically a leveraged investment in technology, so dollar for dollar it is more volatile than the Nasdaq index. If gold goes up 10%, Bitcoin should drop around $5,000. If gold goes down 10%, Bitcoin should go up about $5,000.
Volatility add-ons are somewhat more complicated. Bitcoin has some characteristics similar to options, so its price is higher when things are volatile. The current value of the Nasdaq Index Volatility Plugin is $8,000. That means that if the volatility of the index increases by 50%, expect Bitcoin prices to rise around $4,000 and fall by $4,000 if the volatility decreases by 50%. Bitcoin’s volatility add-on is $6,000, so the numbers are $3,000 gains or losses in the price of one Bitcoin if Bitcoin’s volatility goes up or down 50%.
This suggests that the drop in the price of Bitcoin, and likely cryptocurrencies in general, was in line with expectations given the slump in tech stocks, as well as little change in gold prices and moderating volatilities. Going forward, Bitcoin looks attractive if you expect a rebound in the tech sector and stable or falling gold prices, as well as a return to high volatility. But if you expect poor performance from tech stocks, rising gold, and muted volatility, Bitcoin and cryptocurrencies are not for you. More from other writers at Bloomberg Opinion:
• Matt Levine’s Money Stuff: Crypto Loves Its Shadow Banks
• Lights out for Crypto’s laser-eyed scammers: Lionel Laurent
• Crypto’s lofty ideals of freedom take a beating: Jonathan Levin
(1) To build the proxy portfolio, I collected data on financial instruments with economic relationships to Bitcoin, their levels and volatilities. Volatility is one week’s volatility using a combined high/low and daily close estimator. I used regression analysis to select the best combination of variables to obtain a statistically sound, parsimonious fit that would pass normal diagnostics.
This column does not necessarily reflect the opinion of the editorial board or of Bloomberg LP and its owners.
Aaron Brown is the former Managing Director and Head of Financial Markets Research at AQR Capital Management. He is the author of “The Poker Face of Wall Street.” He may have an interest in the areas he writes about.
More stories like this are available at bloomberg.com/opinion