Thursday, December 21st, 2017
2017 has been a good year for risk assets. As the year concludes, it appears that the riskiest of assets (particularly cryptocurrencies) are performing the best, with no plausible explanation for their market price or a logical basis to determine their intrinsic value.
Away from the speculative frenzy of bitcoins, it is interesting to note that world equity markets in 2017 – as measured by the MSCI world index – have performed at an historic rate. The following table shows that, so far this year, there has not been a single negative month for the world equity index. This has not occurred in any calendar year since the MSCI Index was created in 1988.
The above table suggests that equity markets are overdue for a correction. Therefore, it is our view that active investors should consider the raising of cash from the equity market to avail portfolios of buying opportunities that are likely to appear during the next few months.
As a stockbroker noted this week – “While the current expansion is the second-longest bull market in history, it has to last a few more years to take the gold. The current market, as measured from the financial crisis bottom in March 2009, has lasted for nearly 3,200 days. The longest in history—between December 1987 and March 2000—lasted for 4,494 days.”
However, we are living and investing through extraordinary monetary conditions. The unrelenting manipulation of interest rates by the US, European and Japanese Central Banks has taken both bond and equity market behaviour well away from logic. The well-established behaviour of markets and valuation metrics has been debased and destabilised. This may well be an underlying reason for the emergence of bitcoins.
In world markets, we witness the spectacle of central banks (which created the lowest interest rates of all time) creating a fictitious rationale for the market response to low interest rates. They have convinced many commentators that interest rates are low because the outlook for inflation is benign. However, at least in selective cases, this is blatantly false. Just last night, the Bank of England stated that CPI was 3.1% across the United Kingdom. As the National Bank noted in its morning note to readers – “the GBP could not sustain a rally following a better than expected headline CPI. Headline CPI was 0.3% m/m against expectations of a 0.2% result, while the y/y rate is now 3.1% against expectations of 3.0%. More importantly, core CPI was unchanged and in line with expectations at 2.7% and market pricing for the next BoE hike haven’t shifted from the end of 2018”.
The Bank of England felt that this was a “good” CPI read because “inflation was higher than expected”. Overnight, the 10 year United Kingdom bonds traded at 1.22% and cash rates of 0.5% are expected to stay at that rate for another year.
These types of declarations have deluded economists and commentators alike; the Central Bankers don’t really know what they are doing or what the long-term effect will be. It is our view that investors are captive to markets that price risk (most notably inflation) illogically. Common sense struggles to be heard at times like this, and speculation has become rife.
Today’s interest rate settings and market yields – both for official cash rates and 10 year bonds – exist in spite of observations of world economic growth of more than 3% p.a., world inflation of at least 2% and rising, and with no major economy threatened by recession. It is a world where inflation is becoming a growing threat, yet where passive capital providers (savers and pension funds) are enduring interest rates that don’t even sustain the purchasing power of cash. It is an intolerable situation that has continued for far too long – but may well go on for a few more years.
The sustained period of pathetically low interest rates inevitably brings us to bitcoin: its astronomical rise is captured in our next chart. Readers may well ponder as to whether there is any connection between the manipulation of interest rates, the excessive printing of money and the speculative pricing of bitcoins?
Figure 3. Bitcoin price and the “market capitalisation” of all Bitcoins
Whatever the reasons for the chaotic pricing of bitcoins, it seems that “the needy and the greedy punters of the world” now have something more lucrative to bet upon than the traditional “two flies on the wall”. In a world where monetary manipulation has pushed traditional investing towards speculation, the ultimate “online” gambling game has evolved – bitcoin punting!
It is interesting to reflect on the collective performance of some the great “over paid” punters of the world captured in the next chart. The global hedge funds that profiteered from the collapse of the financial system in 2008 have struggled ever since. Is there any wonder why they have urged the financial markets in the US to establish a futures market for bitcoins? Hedge funds may once again be able to justify their existence, because for the last ten years they have achieved very little – even with the benefit of leverage that costs virtually nothing!
Bitcoin punting is commonly mistaken by many market commentors as a type of investment. With bitcoin followers adopting “real market” concepts – in this case “market capitalisation” – the bitcoin players are trying desperately to convince the majority of non believers (indeed the overwhelming majority of people on earth) that there really is a future for bitcoin.
“There is here a basic and recurrent process. It comes with rising prices, whether of stocks, real estate, works of art, or anything else. This increase attracts attention and buyers, which produces the further effect of even higher prices. Expectations are thus justified by the very action that sends prices up. The process continues; optimism with its market effect is the order of the day. Prices go up even more …” – John Kenneth Galbraith, The Great Crash, 1955
John Kenneth Galbraith, Professor of Economics at Harvard, US Ambassador to India, the pre-eminent scholar of the Great Depression and adviser to Presidents Roosevelt, Truman, Kennedy and Johnson.
The above description of financial bubbles, written six decades ago by renowned economist John Kenneth Galbraith, seems as fresh as ever, with the incomprehensible price action of Bitcoin. “That it ends is inevitable, and inevitably violent. The descent is always more sudden than the increase; a balloon that has been punctured does not deflate in an orderly way,” Galbraith wrote. “The phenomenon has manifested itself many times since 1637, when Dutch speculators saw tulip bulbs as their magic road to wealth,” he noted, adding that he wasn’t making a prediction!
Clearly it would be fabulous if there is a real future for bitcoins. The world’s immense debt problems could then be solved by a crptocurrency that evolved from nothing and created trillions of value to repay the trillions of dollar debts that had previously been funded by the printing of money. Never before would so much value have been created by the burning of energy to solve mathematical problems – but then again, some $15 trillion of fiat currencies has been printed by the European, Japanese and US central banks over the last 5 years.
Market capitalisation is an interesting concept. It normally reflects the total market value of a individual company or an index or a market. Each of these have their value and market price derived from the percieved value of the cash flows likely to flow from their underlying businesses. The equity market capitalisation changes constantly as earnings projections are adjusted and required returns (driven mainly by bond yields) ebb and flow with the perception of risk.
The problem with bitcoins (like gold) is that they don’t generate cash flows and so their value is influenced by a whole range of largely illogical factors. Many of these factors are driven by the intertwining of human weaknesses and pyschology, with herd behaviour being especially important. In comparison, gold is different to bitcoins because it does have some practical uses. It is used in industry, has been used over the past 3,000 years as a currency or store of value, it is commonly used as jewelery, and for many years was useful to fill holes in teeth! Interestingly, while bitcoin has surged, the price of gold has remained dormant; some have suggested that cryptocurrencies are “the new gold”, that is, the more innovative method of hedging fiat currencies.
While we suspect that bitcoin is a “con”, it may well be the result of the “con” of massive and unrelenting quantitive easings (QE) that continue to go unchecked in Europe and Japan. Indeed, if it were not for their QE programs, then arguably the Japanese and most European Governments would now be bankrupt. In the US, time will tell whether the Federal Reserve can actually stop QE totally and reverse its effects over time. However, with Trump tax cuts coming it may well be needed, if only partially, for many more years.
“According to JPMorgan’s latest tally, there is some $10.1 trillion in global government bonds with yields below zero—or 40 times as much as Bitcoin. That is down from the peak of $12.7 trillion reached in July 2016 in the wake of the market panic following the Brexit vote… Of course, this isn’t the product of wild-eyed speculators’ relentless chase of a market’s accelerating ascent, but the result of sober central bankers’ monetary policies. The European Central Bank has been buying 60 billion euros’ ($70.6 billion) of bonds per month. The Bank of Japan, meanwhile, is acquiring Japanese government bonds in sufficient quantity to keep its 10-year yield pegged near zero percent.”
Similar to gold, bitcoins are not printed but are mined, with their value enhanced as the cost (mainly electricity and energy) and the time involved in mining increases over time. This is in stark contrast to the printing of money or currencies which has been undertaken by major Central Banks at an accelerated rate since the GFC and at seemingly little cost.
At this point, there is reported to be 21,000 bitcoins in existence and who owns them is subject to much conjecture. Apparently the Winklevoss twins (remember them from The Social Network, the movie about the beginnings of Facebook?) are bitcoin billionaires. While it is said to be a benefit of bitcoin trading, that at present it is purely an online market, this is also a massive risk for those punting. There is no real regulated centre-point market where participants can assess the demand and supply, or indeed the leverage in the market. With such lack of transparency, manipulation is easy and early and large holders of bitcoin may well be able to leave the market without the hapless buyers (punters) having any idea.
Looking forward, it is likely that at some point the world’s central banks and government treasury departments will take an interest, attempt to regulate and seek taxation revenue from the existence and trading of bitcoins. At that point the game may well be up and we can go back to betting on the two flies on the wall – for at least we can see them!