Courtesy of Matt Sauer, MFSWNB Investments:

We have previously expressed a view that cryptocurrency can act as either a derivative, an asset or a currency. While Bitcoin was questioned for its trading behavior in March 2020, we believe that is explainable by the evolving “state” of Bitcoin. Our analogy is that crypto assets behave like the physical properties of liquid, solid and gas are worth observing to understand the recent trading pattern of Bitcoin.

During the decline in asset prices in March 2020, Bitcoin was highly correlated with equity prices as it was acting like an asset with price discovery altered by deleveraging. Investors leverage assets and because Bitcoin acts as one most of the time, leverage is applied to it during good times and removed from it during panics. The onset of a pandemic was an event few investors had planned for in any asset class therefor asset devaluations were very correlated for a short period of time.

Academic research has not settled on a conviction of whether Bitcoin is correlated to gold or whether it is a hedge against stock price decreases. Dyhrberg [2016.] suggests that Bitcoin can be used as a hedge against stock price volatility. Gold and the dollar can also be hedged. Klein et al [2018] has the contrary view that Bitcoin is not the new gold.

Why the disparity in views? We believe that Bitcoin has distinct correlation coefficients with other asset classes depending on the market’s view of cryptocurrency’s state at the time. When viewed as an asset, Bitcoin may exhibit stochastic distribution patterns with other assets such as stocks and gold. This is Dyhrberg’s view. However, when macroeconomic conditions exhibit such uncertainty that Bitcoin is viewed as a currency it is decoupled from other asset classes. As Bitcoin moves past a critical point, it develops a power-law function vis-à-vis paper currency. A strict power-law cannot be a power distribution, but a truncated power function is possible. In times of dollar crisis, Bitcoin can be a substantial outlier against dollar denominated assets. Power curves occur in venture capital and individual stock performance but not in diversified asset classes. That may be the rub. Bitcoin has the capability of leaving an asset class and becoming an investment not ruled by stochastic probability but rather a truncated power law.

Rapid increases in stock and asset prices usually give rise to pundits calling them a bubble, or in other words prices that have drifted significantly from the mean. Power-laws have no respect for the Gaussian mean, simplistic investment measures such as price/time charts, price/earnings ratios and relative valuation metrics trick the investor into seeing a bubble. Somewhere there is an analyst that believed Microsoft was unbuyable on the Initial Public Offering because the multiple was a little high.

As Bitcoin made its spectacular rise in price during the last 12 years, contrarians have viewed it as bubble. The maxim that one buys it only to hope to sell it to someone else at a higher price is a common view. However, that is viewed in the two-dimensional graph of time and price but does not consider purchasing power parity. If the investor views the world as the dollar is fixed, the first example is valid that another investor needs to pay more. In the world where the dollar floats, the investor wants to be paid more in purchasing power. Although it is still a higher price in dollars upon sale, it was the falling dollar that created the return.

Bitcoin has had price predictions made by its evangelists that make little sense viewed through the lens of an asset class. However, when viewed as a currency Bitcoin frees itself of the shackles of stochastic probability and enters the freedom of being governed by a power -law. Now does the $1,000,000 price target make more sense.

Dyhrberg [2016. Bitcoin, gold and the dollar-A GARCH volatility analysis. Finance Letters 16 85-92]

Klein, T., Thu,H.P. and Walther,T [(2018). Bitcoin is Not the New Gold- A Comparison of Volatility,Correlation,and Portfolio Performance. International Review of Financial Analysis, 59, 105-116.]