Bitcoin in 2020: How To Make The Right Valuation

Since its launch in 2009, Bitcoin has continued to thrill and confuse the global financial markets.

From the outset, the initial case for its value was the invention of digital scarcity. If you’re not familiar with the concept, consider fiat money like the US Dollar, the Euro, or the Norwegian Krone.

How are the supplies of these currencies limited?

In short, any limits that are set are controlled by their respective governing agencies, i.e., central banks. That means that for fiat currencies, limits don’t exist, since their supplies can be theoretically altered at any time.

The fact that Bitcoin has a supply that’s limited by its code instead of the whim of a central authority is digital scarcity. Only 21 millions bitcoins will ever exist and no one can ever change that. Due to this, the consensus amongst Bitcoin’s supporters or “bulls” is that as more bitcoins are bought, its price will inevitably go up and eventually sustain itself at higher and higher levels. Working together with this is as the years go by, less and less new Bitcoin will be issued through what is called a “block reward.”

Generally, a block reward is what’s given to the first Bitcoin miner to “solve for a block.” Solving for a block, in turn, refers to being the first to verify that a group of transactions are legitimate and therefore deserve to be stored in Bitcoin’s distributed database, which is called a blockchain. This name comes from the fact that the database presents itself as a chain of timestamped transactions called “blocks.”

Each block is added through the mining process, which at face value, is the process of making sure that transactions can and should be made by the parties involved as said above. While this may sound extremely similar to the process of “clearing” transactions through banks, mining’s uniqueness lies in the fact that it combines the clearing or settlement process with the minting process into a sort of “digital gold rush.”

Each miner races to be the first to solve for a block and in the end, only one can win out, per block. In return for doing so, they receive the block reward which is 6.25 bitcoins and the only way that new bitcoins have ever been launched into the world, since Bitcoin’s genesis.

To top it all off, neither the mining process, nor Bitcoin’s issuance mechanism(the block reward) can be changed by anyone. Their code is therefore considered to be immutable.

These factors have forever flipped the concept of scarcity on its head, leading to the idea of Bitcoin pioneering the concept of “digital scarcity.”

Using digital scarcity’s core concepts, the first case for Bitcoin having real, considerable value was constructed, which we can then use to look into Bitcoin’s other value propositions.

The below cases help to illustrate how Bitcoin may be considered to be “digital gold,” both through its digital scarcity and periodic cuts in issuance as well as its historical investment performance as a reserve asset, which is what most investors use gold as.

Perhaps the easiest lens through which to understand digital scarcity’s relationship to Bitcoin’s value is the stock-to-flow model, as popularized by the pseudonymous bitcoin analyst, Plan B. Below, you can see an example of how the model looks in practice on a graph.

(Source: Plan B: “Modeling Bitcoin Value with Scarcity”)

As you can see above, the Stock-to-Flow model assumes that Bitcoin’s price will continuously increase as the number of blocks per month do as well. If you think of stock as “currently available Bitcoin” and flow as “Bitcoin issuance,” then it’s easy to grasp how the model reaches this conclusion.

Essentially, in its initial form as above, it considers Bitcoin’s 10-year market data(December 2009-February 2019) and attaches a stock-to-flow ratio to it.

PlanB, the analyst involved, then plugged all of this into a linear regression model to attempt to predict what Bitcoin’s price would be down the road. All in all, the results weren’t perfect but no model is. Still, the closeness of the S2F line(the black line) to Bitcoin’s actual price movements(the colored dotted line) shows that overall, the model’s quite accurate related to historical data.

On a quantitative level, PlanB points out that its accuracy is backed up by the existence of what is termed a “power-law relationship,” which refers to the fact that both lines come together in a nearly straight line. The fact that this relationship points to a 95% correlation can be taken to mean that to date, the stock-to-flow model is the most accurate one out there for tracking Bitcoin’s price growth as its scarcity increases over time.

Since immutably(forever) increasing scarcity is Bitcoin’s monetary policy, we can take this and the above as the basis for Bitcoin being an improved store of value, compared to gold(digital gold).

On top of the stock-to-flow model making a strong case for Bitcoin’s status as a store of value, there’s also considerable evidence that like gold, Bitcoin is a strong diversifier for just about any sort of portfolio.

CoinShares, one of the world’s leading cryptocurrency research firms, released a report last month that charts the performance of a investment portfolio with 4% Bitcoin from October 2015- July 2020, as compared to the performance of a traditional 60% stock, 40% bond portfolio and others, over the same period of time.

They chose 4% Bitcoin because they had set a benchmark of increasing a portfolio that was already traditionally weighted (60/40 stocks/bonds) by 120 basis points in terms of its risk budget(its overall potential for risk).

What they found is significant for Bitcoin’s value proposition.

When compared to a traditional investment portfolio, which achieved 9.1% annual returns with 8.6% volatility, the portfolio with 4% Bitcoin achieved 18.8% annual returns with 9.8% volatility. All of this, you can see illustrated in the table below, which is from their report.

What this shows is that Bitcoin is not only likely a good store of value, as described above, but also a powerful diversifier, especially if you compare its performance to that of gold as well as the fact that its Sharpe Ratio is basically double that of everything else listed.

In case you’re not aware, a Sharpe Ratio is a well-known measure of “risk-adjusted returns” or true returns after risks like volatility are taken into account. Generally, a higher Sharpe Ratio points to a more efficient portfolio with higher returns.

With this in mind, consider the fact that CoinShares’ research found that a portfolio with only 4% Bitcoin carried a 1.67Sharpe Ratio, as opposed to the 0.78 Sharpe Ratio of a traditional portfolio.

Now, the true impact of Bitcoin as a diversifier seems clear since from 2015–2020, it was found to have more than doubled the efficiency of the portfolio it was in, compared to its aggregated risks.

Since the above represents only one group’s research, we conducted a deep-dive and found that another well-known research group, SeekingAlpha had also carried out similar research this year. Using market data from October 2014-June 2020, they first compared the performance of Bitcoin alone to the performance of equities and bonds, using well-known ETFs(exchange traded funds) as indices (the SPY and TLT) for the latter two.

What they discovered was that “on a risk-adjusted basis, Bitcoin has been a stronger investment than the other asset classes(equities and bonds from 2014–2020).” Here it’s reasonable to ask: does this also mean that Bitcoin can be a hedge against market crashes in equities and bonds as well?

In their research, SeekingAlpha’s analysts also concluded that Bitcoin was negatively correlated with the bond markets during the same time period. This, at face value, can be taken to mean that Bitcoin goes up to a certain extent when bonds go down, though it’s important to note that for a hedge to be “perfect,” it needs to have a negative correlation of 100%(-1). Since SeekingAlpha’s research found Bitcoin’s negative correlation with bonds to be only -0.08 or -8%, it doesn’t fit this mold.

Even so, 8% is nothing to turn away from. With that in mind, an efficient portfolio can be constructed that includes both bonds and bitcoin. Before considering what that could look like, however, it’s important to take SeekingAlpha’s results of comparing stocks to Bitcoin into account as well.

From 2014–2020, they found that Bitcoin had a “moderately positive” correlation of 0.23 or 23% with stocks. Though this may seem low, it historically indicates a statistically significant relationship between two variables or in this case, assets.

Using this number, it can be said that generally, there’s a good chance that if stocks increase, then Bitcoin does and vice-versa. This was seen in practice when in March of this year, Bitcoin plummeted 50% in connection with the stock market crash due to the world being in the thick of Covid19.

Still, since this number is only 23%, it’s important to keep in mind that this sort of event won’t always occur. In fact, the majority of the time, the data shows that Bitcoin won’t move directly with stocks.

If any of the above seems confusing, that’s because it is.

If the results of SeekingAlpha’s back-tested portfolios (portfolios based on past data) in the same study are considered, then it’s possible to get a clearer idea on what sort of effect all of these correlations have in practice.

Using historical data from 2014–2020, SeekingAlpha’s team constructed four different portfolios, one with no Bitcoin, and three with 5% Bitcoin but varying amounts of stocks and bonds, the specifics of which you can see below.

(Data from SeekingAlpha- used for educational purposes)

Here, it’s readily apparent that any portfolio with Bitcoin produced higher returns over the 5+ year period studied. Additionally, when 55% stocks, and 40% bonds were used, the highest Sharpe Ratio was produced, which points to a portfolio being at a considerably efficient state in terms of risks versus returns. Furthermore, if one asset such as Bitcoin produces such a higher Sharpe Ratio as compared to essentially all other options, it can be said that it is the most efficient diversifier available, based on the time studied.

This, in turn, corroborates both CoinShares’ and SeekingAlpha’s conclusions that appear to indicate the same as well as that by extent, Bitcoin does work as a store of value and “digital gold.”

Still, the question remains: what about Bitcoin’s status as a hedge, more on a global scale?

What if, however, Bitcoin could be both a powerful diversifier and an effective hedge against global economic crashes?

From 2019–2020 in particular, Raoul Pal of the Real Vision investment group seems to have taken this position. Before jumping into the specifics of Pal’s position on Bitcoin, it’s important to understand a bit of his background. Pal spent a number of years working for Goldman Sachs and other firms in hedge-fund like sectors, before he struck out on his own and built a name for himself as what is called a “global-macro” investor.

Generally, what this refers to is someone who practices macro-investing, which involves following all sorts of global trends and attempting to predict how they might affect the performance of certain asset and commodity classes as well as the market-at-large.

This means that a macro-investor is focused on the big picture and the reason that Bitcoin is said by Pal and others to fit into that picture is because of its decentralized nature as well as its long-term performance as a store-of-value(digital gold) through all sorts of global events.

In Pal’s most recent macro report that was released to anyone who’s a Real Vision member, he said that his goal over-time was to shift his portfolio of “liquid” assets to 75% crypto.

This, however, is nothing new.

Since at least last year, Pal’s been vocal about Bitcoin being his “big idea” or the investment that he’s focusing most of his energy on because he believes it truly is a global recession-hedge(global macro hedge) or an asset that can protect investors when global economic recessions occur and everything else falls.

His key reasoning for this belief is that because of how Bitcoin’s monetary policy works(because of its digital scarcity), it’s an effective bet against the traditional financial markets which depend on fiat-based monetary policy.

On Stephen Livera’s podcast, he summed up this view by saying that massive money printing should continue worldwide and consequently, “anyone who understands gold can understand the value proposition of Bitcoin” and that macro-investing strategy and Bitcoin are becoming one. On top of this, he added that he sees Bitcoin’s growth as largely, but not only “retail-driven,” pointing out that investors who are in their 30’s or younger have an easier time understanding the digital world and its investment opportunities like Bitcoin.

Put this together with the growing confidence of institutional investors and even banks in Bitcoin as illustrated through Paul Tudor Jones, Micro Strategy, and numerous other cases like the performance of Galaxy Digital with Bitcoin, and you understand Pal’s rationale for Bitcoin as a hedge.

Before you go and base an entire strategy on the above, it’s necessary to keep in mind that Pal’s ideas haven’t exactly been tested in practice yet, which is a fact he readily admits to and counts on. Therefore, the only way to see whether Bitcoin will protect the world against an economic recession is if one occurs.

Because Pal’s is a truly interesting case for Bitcoin’s value, we at NBX, plan to analyze it more over time.

What these examples tell us is that there’s a strong case for Bitcoin being “digital gold” and therefore, a store of value as well as a diversifier. Additionally, particularly through the examples presented in SeekingAlpha’s research and RealVision’s(Raoul Pal’s) analysis, it seems apparent that Bitcoin could become a powerful hedge against global market volatility and therefore a key part of any macro-driven(global event driven) portfolio over time.

Using all of these conclusions, you can begin to develop your own trading/investment strategies with regards to Bitcoin while keeping in mind, that the cases above are not its only value propositions and each of them carries its own risks.

What are the risks of the cases discussed in this article?

While the risks of Pal’s macro-case have already been addressed, those of Plan B’s Stock-to-Flow model, CoinShares’ research, and SeekingAlpha’s analysis have yet to be mentioned. With regards to the Stock-to-Flow model, the primary risk is that like any model that attempts to predict future pricing, it will never be exact. Instead, it should be taken as a something like a technical analysis indicator

If you know technical analysis, then you know that it involves using candlestick patterns and other measures to attempt to pinpoint an asset’s most likely future price movements. Historically, TA is at its best when many indicators are used together since that indicates that the analyst in question has considered an asset’s future movements from all possible angles.

Keeping these ideas under consideration, you’ve got the basis for how to apply the stock-to-flow model in practice.

In terms of CoinShares’ and SeekingAlpha’s research, the risks are even more cut-and-dry. Since both used historical data, their conclusions shouldn’t be taken as reliable indicators of future performance alone.

Instead, the best way to approach them could be to work their data into your own valuation model for Bitcoin, alongside other indicators like the S2F model and macro-economic events(possible recessions,etc.). If a model hits all three of these areas, then it’s reasonable to assume that it will be more effective at valuing Bitcoin than one that leaves one or more models out of the equation.

All in all, whatever you decide, it’s best to consider this discussion as a starting point into your understanding of what makes Bitcoin valuable. Over time, you can expect more content from us at NBX that explores the other valuation models of Bitcoin as well. If that interests you, check out our Knowledge Base as well as our blog.

Norwegian Block Exchange (NBX) is a pioneering, forward-thinking and client-oriented Norwegian cryptocurrency exchange, custodian and payment system. Trade with us at nbx.com, follow us in Twitter or Facebook📲✔️