December 15, 2024
This newsletter issue takes a look at the rise of digital assets, to analyze the trends behind them and see how to manage risk when investing in them.
From Bear Market to Bull Market
My final newsletter issue of 2023 was called “The Monetary Gates are Open” and was published in November of that year. Although most of my newsletter issues focus on macroeconomic topics, that particular issue focused on how technology is shaping (and will continue to shape) global finance. The emphasis was on bitcoin and stablecoins and how they pierce global capital borders, despite the fact that the industry was in a bear market at the time.
Bitcoin’s price was around $37k back during the time of that newsletter’s publication, and recently it touched over $100k for the first time. And by doing so, it also reached about $2 trillion in market capitalization, making it one of the largest and most liquid individual assets in the world.
The total stablecoin supply was about $138 billion at the time of that newsletter, and today it’s over $210 billion, which represents a 52% increase in a little over a year. Stablecoins are becoming a significant way for people around the world to access dollars, and the stablecoin issuers are becoming rather large marginal buyers of Treasuries as collateral.
So, I think we’re due for a bull market checkup. It’s easy to kind of ignore something when it’s in a bear market and not too big, but when prices are up and the markets are growing, that something tends to get more media attention and investor attention. And from there, there are inevitably a lot of investor questions as well.
Global Demand for High Quality Liquid Assets
I’m writing this newsletter issue from Egypt, where I live for part of each year. And in my November 2023 newsletter, I used Egypt’s broad money supply as one of my examples.
Back then, the latest reports said that the country’s broad money supply was about 8.7 trillion Egyptian pounds. Now it’s 11.2 trillion and rapidly climbing. That’s a 29% year-over-year increase.
Naturally, people in Egypt want to store their savings in something with less supply growth than Egyptian currency. The most popular investment locally is real estate, and as a result, there is a lot of empty real estate as people hold onto unfinished second or third properties to store value in. And of course the limitations of real estate are that it’s illiquid, it’s usually possible to build a lot more of it, and it comes with perpetual maintenance costs.
Gold and dollars are other popular choices. Dollars grow in supply rapidly, although not nearly as rapidly as Egyptian pounds, and are globally recognized. But it’s risky to hold dollars in levered foreign banks that are not FDIC insured, and if they are held physically then they give the holder no interest to offset their supply inflation. Gold grows in supply even more slowly, and thus has outperformed dollars over the long run, which makes it a popular choice for longer-term savings.
Bitcoin is a newer asset with less supply growth than gold (ultimately capping out at 21 million coins, which are divisible into 2.1 quadrillion base units), and its popularity differs by country. In Nigeria, bitcoin and stablecoins are pretty popular, whereas in Egypt they’re both in an earlier phase of catching on.
Local stocks aren’t particularly successful or popular for Egyptians to invest in. Some people have foreign bank accounts or access to foreign stocks, but due to the overhead costs of such accounts, it’s generally limited to those with some substantial degree of wealth. Equities and other American assets are permissioned. Same for European assets, and so forth. Bearer assets that are not securities, like gold and bitcoin, are permissionless assets. They can be bought and sold in multiple markets and currencies globally, and there is no authority that can unilaterally block access to them.
The Egyptian government often tries to peg its currency at an artificial exchange rate for a period of time. As a result, a black market develops where the real price of money is found between more buyers and sellers. “Black market” sounds like a scary term, but for example I know physicians and engineers in Cairo that hold dollars in their apartments that originated on those black/street markets. They’re just trying to protect their liquid savings from the ravages of currency debasement.
This time last year, the official exchange rate between Egyptian pounds and American dollars was 30-to-1, but the real rate on the ground if someone wanted dollars was about 50-to-1. The Egyptian government cracked down on black market dealers pretty hard to reduce liquidity in that market, and then eventually devalued its currency to around 50-to-1 where the black market was already pricing it at, where it rests now with another pseudo-peg in place until their next devaluation.
One of the powers that stablecoins have is that they go around borders more easily than physical dollars. Bank transactions are tightly controlled, and if you go through an airport, they often check your bags for cash and stuff like that. In a country like Egypt, part of that is to crack down on peoples’ ability to access dollars at the real market rate. They don’t want leaky capital borders; they want to be able to control them and price them unilaterally, or get as close to that as possible without being too burdensome on travelers.
Assets like bitcoin and stablecoins can be physically transported with infinite value density by merely memorizing or writing down 12 words. And they can be virtually sent to anyone who can use a message application by sharing a string of numbers, or by holding up a barcode on a video call.
So, if an Egyptian does freelance work for someone in say the United States or elsewhere, they can be paid directly in whatever monetary units that they and their client agree on, and at the exchange rate that they agree on, rather than go through centralized permissioned payment pipes with centrally mandated exchange rates.
Egypt has a population of over 110 million, but we can extrapolate these issues to billions of people worldwide. Over 80% of the world, or over 6.5 billion people, live in countries that are classified as developing. And what billions of them have in common is that they want to hold globally-recognized liquid scarce assets as savings or investments to protect their purchasing power from local debasement.
For nearly 16 years now, bitcoin has been emerging as a preeminent asset to hold for that purpose over the long run, and with a high degree of portability. And for those with tighter volatility requirements, for over a decade stablecoins have been emerging as a great way to maintain the purchasing power of working capital over an intermediate term.
Managing Bitcoin Volatility Risk
Stablecoins are relatively straightforward; they’re digital eurodollars. They’re like offshore dollar-denominated bank accounts with the overhead costs compressed to near-zero, which makes them available to everyone with a phone rather than just the upper class. Custodial dollars on digital rails.
Bitcoin is a bit more complex to grok. And one of the challenges that potential buyers of bitcoin run into is that it always looks either dead or in a bubble.
On a linear chart it always looks absolutely insane:
On a logarithmic chart it looks more reasonable, but it’s not a view that people see as often:
Either way, potential new investors come across a dilemma. During a bear market they wonder if it’s dead for good this time, and the media has been telling them it’s bad for a decade and a half as they’ve missed out on enormous gains. During a bull market, they wonder if they will get in too late and suffer an 80% drop right after they buy. Both of those concerns are understandable.
I can’t tell you for sure what bitcoin’s price will do in any given timeframe, and I would recommend distrusting anyone who says they can. I’ve been recommending it since it was $6,900/coin, but I never really know what it’ll do in any given multi-month period.
However, I do think there are some “situational awareness” checks that an investor can do to at least understand some of the risks and opportunities. An investor can at least keep track of some of the major forces that drive price around, to see where they stand with them.
I’m listing four of them here that I think are particularly important to maintain awareness of. I don’t actively trade around these variables, but I do tend to manage expectations around these variables.
#1 Liquidity Correlation
Ever since the Bitcoin network became large and liquid enough to be a “macro” asset, it has had a pretty strong correlation to various measures of global liquidity.
In a research report that I collaborated with Sam Callahan on, we found that over the past 11 years, the asset that most closely correlates to measures of liquidity is bitcoin, and that the price of bitcoin moves with liquidity 83% of the time in any given 12-month period.
Generally speaking, if you expect a sizable contraction in global credit, bitcoin’s exchange rate is more likely than not to run into challenges during that period. On the other hand, if you expect an expansion of credit and/or monetized fiscal deficits, then bitcoin’s exchange rate is likely to do pretty well.
#2 Price to Cost Basis Ratio
The price of bitcoin at any given time is not necessarily the “real” price. It’s the marginal price of the coins that are trading hands at the current time. This applies to both the upside and downside, during euphoric bull markets and despondent bear markets alike.
An analogy I like to use is that of houses on a street. Suppose there are 50 houses on a street, each estimated to be worth $500k, but none of them have sold in the past couple months. One of them suddenly sells for $600k, and it’s not significantly different than any of the others. And then another sells for $600k as well.
A lot of the estimated prices for houses on the street will now “reset” toward $600k based on these comparable sales, even though only 4% of the houses (2 out of 50) sold for that new price. Prices are set on the margin, and the latest data suggests that the houses are now worth $600k. There was $1.2 million in volume (two houses for $600k each), and yet the street gained $5 million in market capitalization (50 houses growing by $100k in each in price).
If ten more homeowners on the street immediately want to sell at $600k, will they all get that price? Potentially not. We should be careful about assuming that $600k is indeed the new liquid price for houses on that street.
However, if over the next couple years, ten more houses do indeed exchange hands at an average price of $600k, then we should have more confidence that $600k is indeed the new liquid clearing price for houses on that street. More houses trading hands at that price over a longer period of time gives us a stronger price signal than a few houses trading hands at that price during a brief window of time.
This is an overly simplistic and illiquid example, but it illustrates the point. The same is generally true for bitcoin, although all of it is more liquid and global.
To analyze this, I look at the on-chain cost basis. We can’t directly see the trading volume on any given exchange or any given broker (other than what they report, which might or might not be correct), but we can measure the price at which bitcoin moves on-chain, including to and from exchanges and brokers around the world.
The on-chain bitcoin cost basis is a measure of what the total Bitcoin network is worth, with each coin (or technically each UTXO) listed at the price at which that coin last moved. In other words, it’s like measuring the value of that street of houses by the sum of prices of all the houses at their last sale price, rather than assuming all of them are suddenly worth $600k simply because two of them recently changed hands at $600k. Over time, as more of them trade hands at $600k, it starts raising the average cost basis of the street and gives us more confidence that this really is the liquid clearing price for houses on the street.
The blue line below is the cost basis for the network, the black line is the market capitalization of the network, and the orange line is the deviation from the norm between those two:
-When bitcoin is in a raging bull market, its market capitalization tends to stretch way beyond its on-chain cost basis. When that happens, it pays to be cautious. Nobody can tell you what market capitalization to cost basis ratio it will peak at for the cycle, and so it’s not a top-signal per se, but when it’s historically high it should cause an investor to be more cautious with expectations.
-When bitcoin is in a deep bear market, its market capitalization has historically dipped a bit below its on-chain cost basis. When bitcoin is near or below its cost basis, that has historically been an excellent buying opportunity, and in the past I’ve pounded the table on it when it reached those levels. There’s no guarantee it’ll reach those lows again in the future. Or if it does, the average cost basis might be higher than the current price.
Right now, bitcoin is middling in terms of this ratio. It’s not at the levels that historically mark multi-year price tops. But it’s at a level where investors shouldn’t be surprised by periods of consolidation.
When bitcoin surges to a new high, that’s like a “pioneer price.” That’s like the first couple houses on a street selling for new highs. And then over months and years, as more and more bitcoin trades hands at those higher prices, it raises the average cost basis and makes that price more real, more liquid, with a substantial market depth at those new higher prices.
I often see analysts from traditional finance, who are not well-studied on bitcoin, comparing every local bitcoin surge with the major market tops of 2017 or 2021. However, they are often doing so without awareness of these types of signals, and without understanding that the euphoria level is quantifiably lower than those major historical price peaks.
And so to repeat, while any given metric including this one is not a sure thing in terms of price forecasting, it’s something to at least be well aware of before making major investment decisions and/or before publicly comparing the price at any given time to major tops of the past.
#3 HODLer Waves
This third metric relates to the prior one, and is another way to look at it.
When bitcoin is in a bear market, long-term holders (who on average understand the asset pretty deeply) are generally unwilling to part with it. Relatively few new buyers are entering, and so coins are consolidating into “strong hands” of long-term holders and those who are dollar-cost averaging into the asset. This starts to build up a supply crunch, and is like a coiled spring.
When macroeconomic liquidity conditions improve, or the supply crunch just becomes too acute, the price eventually breaks out. Higher prices attract attention and new buyers. People who previously thought bitcoin was dead for the 3rd or 4th or 5th time wake up and realize it is not.
And at those new high prices, some long-term holders do sell to those new buyers. They might be up 5x, 10x, 20x, or more on their holdings. They might want to rebalance their asset exposure, or they might want to upgrade their consumption levels. Either way, they are willing to part with some of their bitcoin at these new all-time highs. And as a result, coins distribute more widely.
This chart shows the percentage of coins that haven’t moved on-chain in at least one year. The ratio rises during bear markets and then falls during bull markets:
I see a lot of bitcoin bull analysts looking at things like ETF inflows and other buyers relative to new bitcoin generation (which is currently only 450 new coins per day) and see them assuming the price has to go to the moon any minute due there being way more buyers than there are new bitcoin. During the 7-month price consolidation from March 2024 to November 2024, a lot of them were confused why the price wasn’t surging.
And of course, the variable is that there are a lot of sellers at new highs. The biggest source of supply for new buyers is not from mining; it’s from long-term term holders that are selling. Most of them are not cashing out and selling their whole stack, but they’re trimming. And this happens cycle after cycle during bull markets.
Back in 2013, there was a point where 48.3% of the coins hadn’t moved in over a year, even though the network was still relatively young. The resulting bull market unlocked a lot of those coins, and the ratio fell to 35.7% in 2014. This was a 12.6% reduction in the ratio.
In early 2016 after a long bitcoin bear market, 61.5% of coins had not moved on-chain in over a year. By the end of the two-year raging bull market that followed, less than 41% of coins hadn’t moved in over a year. That massive run-up in price unlocked a lot of selling from long-term holders, to the tune of about 20% of coins. That was the biggest unlock of coins of any bull market.
And then in 2020, again after a long bear market, over 63.6% of coins had not moved in over a year. By the end of the bull market over the next year, this figure was below 54%. About 10% of previously locked-up coins had moved.
After the latest bear market toward the end of 2023, over 70.7% of coins hadn’t moved in over a year. That figure is down to about 63.2% now, and so about 7.5% of previously locked-up coins have moved. I expect that this bull cycle still has room to run, although nobody can be sure. I consider it useful to monitor these waves of distribution to see how many coins a given bull market has unlocked.
#4 Geopolitical Standing
If an investor expects an extreme negative political reaction, like the United States government making it illegal to own bitcoin despite all of its various checks and balances for power, then naturally that’s going to make them less likely to buy it.
On the other hand, if politicians or the president elect are actively endorsing it, and nominating people for government positions that are positive toward it as well, then that can encourage some of them to buy, since they view it as a de-risking of the asset. Voters and donors have spoken with pretty clear actions lately. Some countries such as El Salvador and Bhutan hold bitcoin on the sovereign level now, and I have credible reports that others are as well.
Many countries have flip-flopped on various bans of bitcoin, where they try to ban it, and then either realize it’s not working or have another part of their government override them and say the ban was an overreach. Bitcoin is basically just a decentralized spreadsheet, so when governments try to ban it, it says more about them than about the asset itself.
And so, along with all of the various liquidity correlations and on-chain distribution cycles, it makes sense to be aware of big shifts toward the positive or negative in terms of the Bitcoin network’s geopolitical standing. The SEC effectively being forced by courts to approve the spot bitcoin ETFs, and the election of Donald Trump for president, have been recent catalysts for the asset that were widely seen as beneficial for the price of bitcoin by investors.
Bitcoin as a Communication Protocol
Fully exploring the Bitcoin network touches on a lot of different areas and thus requires a lot of time to analyze, but I continue to view the communication protocol framework as particularly relevant.
Technologies like Ethernet, Internet Protocol, Simple Mail Transfer Protocol, and Universal Serial Bus are among the key communication standards of our day. Of those, USB is the youngest at 28 years, while some of the others on that list are over 50 years old and still going strong. When a protocol wins out over competition in its adoption phase, it cements itself with a powerful network effect for decades at least, and we don’t yet really know the upper bound lifetime that these communication protocols will have because so far the answer has been that they last indefinitely.
What replaced USB? USB 2 did. What replaced USB 2? That would be USB 3. And now’s it’s up to USB 4. Ethernet has gone through a longer and larger set up of upgrades than that; those cables up to their eighth version now.
It’s not that these technologies can’t be replicated; it’s that any replicator starts with an enormous disadvantage because billions of devices have USB and Ethernet connections, and all major email clients use SMTP, and so forth. Their network effects are extremely powerful and long-lasting, unless something can come out that is 10x better and completely disrupts it. And that’s hard to do because these standards can update over time in backward-compatible ways to remain current.
Similarly, it’s not that hard to make a Facebook clone, or a Twitter/X clone, or an Instagram clone. The hard part is getting billions of people to shift over to the clone, since the existing set of users on those apps is harder to replicate than the software itself.
Likewise, you could download all of the information on Wikipedia onto a standard storage drive, and host that data somewhere. That’s easy. The hard part to replicate about the real Wikipedia is not the software or the content. Instead, the hard part to replicate has to do with the network effects. There are millions of links from websites around the world pointing to pages on the real Wikipedia, which directly sends traffic to them and helps them rank near the top of search engine results. And they have an army of volunteer editors constantly updating it. And they have major server capacity to handle the high traffic. Getting all of that to switch over to a Wikipedia clone would be incredibly hard.
In other words, we normally think of technology as something that keeps getting disrupted over and over, but at the foundations, that’s not really the case. Communication protocols are languages, and languages tend to stick around for a long time. The complexity is pushed toward the edges, or toward higher layers, so that the underlying foundation can remain simple and be useful for generations. The same is generally true for social networks, but so far communication protocols are even longer lasting since they are less about trends and more about meeting basic needs.
For almost 16 years now, Bitcoin has been the dominant cryptocurrency network despite thousands upon thousands of competitors and several forks. Anyone can copy it, but like copying Wikipedia or Ethernet or any of these other examples, those copies start with a nearly infinite disadvantage due to not sharing in the existing network effect. Bitcoin’s market size, liquidity, number of nodes, and amount of mining hashrate are what keep it secure, liquid, and self-reinforcing relative to its competition. And it gradually updates over time.
This makes the Bitcoin network the most immutable database in the world, and technically the most powerful computing network in the world. And it just so happens that the killer use case for an immutable database is as a ledger. Portable liquid capital. Global open-source money.
There are non-monetary applications for it as well. Guatemala timestamped its 2023 nationwide election results into the Bitcoin blockchain in 2023 in nearly real time, which adds a degree of auditability and immutability that no other election results have. And then, during the 2024 U.S. election, Screven County in Georgia became the first U.S. county to use the same method to timestamp its election results in real time into the Bitcoin blockchain.
Bitcoin Bullish Thesis 101
Along these communication protocol lines, a bullish investment thesis involving buying and holding some bitcoin comes down to a couple main points:
-The first point is that in a world of closed-source centralized ledgers, an open-source decentralized ledger is valuable. Specifically how valuable is hard to say, but right now at $2 trillion it’s only worth about 0.2% of global capital. It would have to approximately 10x in price from here to reach the market capitalization of gold, which is itself only 2% of global capital. Whatever its total addressable market is, I think it’s well north of where it is now. I certainly want (and have) more than 0.2% of my own capital in bitcoin, and more than 2% as well.
-The second point is that these open-source decentralized ledgers have network effects, and thus the largest and most robust one is the most valuable by far. If someone expects it to get completely disrupted at some point, then they might rationally avoid investing in it. If they instead expect that it’ll keep updating and remain in the lead with its relatively simple design like other communication protocols have for decades (which is my base case), then it has a potentially indefinite expected lifetime.
I continue to view the bullish bitcoin thesis as alive and well for a portion of one’s portfolio. It’s up more than 10x in price since I first publicly recommended it, and I still don’t see a compelling reason to sell it or to view it as structurally overvalued. I still think it has considerable room to run higher in the years to come.
Portfolio Updates
I have several investment accounts, and I provide updates on my asset allocation and investment selections for some of the portfolios in each newsletter issue every six weeks.
These portfolios include the model portfolio account specifically for this newsletter and my relatively passive indexed retirement account. Members of my premium research service also have access to three additional model portfolios and my other holdings, with more frequent updates.
M1 Finance Newsletter Portfolio
I started this account in September 2018 with $10k of new capital, and I dollar-cost average in over time.
It’s one of my smallest accounts, but the goal is for the portfolio to be accessible and to show newsletter readers my best representation of where I think value is in the market. It’s a low-turnover multi-asset globally diversified portfolio that focuses on liquid investments and is scalable to virtually any size.
And here’s the breakdown of the holdings in those slices:
Changes since the previous issue:
- No recent changes.
Other Model Portfolios and Accounts
I have three other real-money model portfolios that I share within my premium research service, including:
- Fortress Income Portfolio
- ETF-Only Portfolio
- No Limits Portfolio
Plus, I have personal accounts at Fidelity and Schwab, and I share those within the service as well.
Note that the annual price for this subscription has remained unchanged for the past five years at $199/year, which is purposely set low relative to most investment research subscriptions to keep it widely accessible.
By the end of this month, the price will increase to $249/year for new subscribers to keep up with five years of inflation, and I plan to leave that price in place for a while. This price change will not affect those with existing active subscriptions, or those that buy between now and the end of the year. It will be the new rate for those that join in 2025.
Final Thoughts: Broken Money
For those that want a deeper dive on the topics described here, I suggest taking a look at my 2023 book, Broken Money. It’s one of the best-sellers in all its categories and continues to sell very well as we enter 2025.
The book focuses on how technology shapes what we use as money, from the dawn of written ledgers to the modern day with Bitcoin, stablecoins, and similar technologies.
Best regards,
