Wide Angle Shot: BTC - a rational bubble or more?

From a macroeconomic and financial market perspective, the current "sweet spot" for decentralized and non-governmental currencies such as bitcoin can be partially explained. The currently coordinated massive monetary and fiscal policy stimuli in all major economic areas feed diffuse medium- or long-term inflation concerns. Fears about the long-term monetary stability of established currencies are increasing, and the outlined topics are being actively discussed in the media. In addition, the perception of inflation risk on the financial market has also increased in the short term in recent weeks, as yield increases in some market segments show. In addition, lockdowns in many large economies and the resulting forced accumulation of large-scale savings, even among young investors, have again increased the turn to pro-risky “There Is No Alternative” investment strategies in the current low interest rate environment, supporting investments into stocks or even more risky assets. The new home office reality and the fact that the stock market boom in 2020 was driven by retail investors for a longer time have now also favored digital currencies. Especially since, as with the stock market recovery in 2020, where institutional investors jumped on board partly with a delay, institutional players also tended to follow late in the crypto- or Bitcoin-boom.

Furthermore, Bitcoin and other cryptocurrencies benefit from the fact that many other traditional investment opportunities either offer hardly any return potential or conventional financial markets are already very highly valued after the recovery in 2020. With Bitcoin and its counterparts, however, there is still a pronounced and large valuation uncertainty — and thus more price discovery potential and future fantasy.

All in all, we think that the current Bitcoin boom is not entirely irrational — even if there are considerable long-term valuation uncertainties. A financial market bubble is always rational as long as investors believe that other investors (still) find the investment story attractive. And of course every investor who is invested always believes that he will be smart enough to recognize the bursting of a bubble in time. The previously outlined and recognizable patterns of a rational financial market bubble also explain part of the strong volatility in Bitcoin.

It is therefore all the more important to be aware of the driving forces behind Bitcoin prices and to develop an understanding of valuation models. One such valuation approach, which has caused a stir in the crypto scene in recent years, will be presented in the following.

While the biggest catch-up in history made the hearts of classic stock investors beat faster last year, bitcoin fought its way back to its old strength almost unnoticed at the beginning. At the latest, however, the digital currency has been the talk of the town again since it surpassed its old all-time high. This is understandable, because an annual performance of more than 300% makes even some US stock investors who are used to success turn green with envy. The fact that Bitcoin & Co. have found their way back into the media landscape and are once again interesting for a broader mass after the slump in 2018 is also thanks to various analyst statements and their price targets. One bitcoin is soon to be worth 50,000 dollars. 100,000 dollars is also supposedly within reach. 1,000,000 dollars in a few years. Or as it is often said in the crypto scene: To the moon!

Such figures sound as if they were plucked out of thin air and almost illusory. To be fair, however, it must also be said that a price target of around USD 40,000 for the beginning of 2021 would have been considered at least as unlikely a year ago. So what is really behind such a bullish scenario? And what has become of the loud criticism of Bitcoin & Co.

Admittedly, a significant part of the currently ambitious price targets is not completely pulled out of thin air, but is actually based on models. This is still a relatively young development. For a long time, there were hardly any possibilities to calculate the fundamental or intrinsic value of Bitcoin & Co. Recently, however, various models for performance estimation have become established, which are based on methods from stock and commodity valuation and enjoy broad acceptance in the crypto scene. One of these is the so-called "stock to flow model", subsequently referred to as the SF model for short.

Stock to Flow actually comes from the commodity sector, with the model describing the scarcity of a good as a price indicator. Essentially, the model looks at the relative difficulty of producing a good. In short, the more difficult it is to create a new product or extract a commodity, the higher the scarcity. Gold is a good example here.

The ratio between the total amount of gold in existence (stock) and the amount mined and put into circulation per year (flow) is called the stock to flow ratio. If we divide the total stock of available gold by its annual production, we get an SF ratio of about 60. This implies that it would take about 60 years to obtain the current stock of gold with current production. The higher the SF value, the scarcer the commodity and the higher the probability of value stability. That is why gold is often considered a safe haven.

We can also make use of this principle with Bitcoin, which is not called digital gold for nothing. As can be seen in the following chart, there is a strong relationship between the Bitcoin price and the respective SF ratio, which serves as the basis for modelling the expected future price.

We have the amount of bitcoins mined so far (stock) on one side and the number of new bitcoins coming in (flow) on the other. The advantage of Bitcoin is that, unlike gold, we know exactly how much will be mined in the future. This is because the amount of new Bitcoins is precisely defined in the protocol. It is reduced by half at regular intervals, which is the case approximately every 4 years. In technical jargon, this is known as the Bitcoin Halving Event.

In 2009, when Bitcoin was launched, the reward for each mined block was 50 BTC. In 2012, after the first halving, it was 25. In 2016, it was only 12.5. And since May 2020, it has only been 6.25. Halving thus reduces the amount of newly created Bitcoins, thereby creating scarcity and regulating the Bitcoin inflation rate. And since we know these regularities, we can model the course of the SF ratio into the future.

We see that with the model, at least in the past, price mapping has worked relatively well. Especially in the course of the previous three halving events (black lines in the upper chart), significant price increases could be expected historically. This is also in line with the recent performance after halving from 12.5 BTC to 6.25 BTC in May 2020.

It is important to emphasize that this is no guarantee of future accuracy. Although the model has a good statistical fit, it also shows how much the actual price can deviate from the model price in the meantime. Moreover, the SF model neglects other important parameters. Political and legal constraints have as little influence on the calculation as macroeconomic developments and other demand-side factors. The model is based purely on the principle of scarcity. And since the flow will continue to decrease in the coming decades, the resulting increase in the SF ratio results in exorbitantly high price targets. Incidentally, this also applies to many more advanced valuation approaches, most of which, however, use precisely the model presented as a basis.

Although this makes it possible to understand the exaggerated forecasts of some "cryptoprophets", extreme caution is advised in view of the highly simplifying model assumptions.

Above all, because in technical terms, apart from the first mover effect, bitcoin is not really in the best light. It is true that the infrastructure has been increasingly improved, as exemplified by the BTC ATMs available worldwide, and the transaction volume also continues to increase. However, the technical inferiority and especially the extremely high energy consumption could increasingly become a problem in the future. After all, the Bitcoin network consumes about as much electricity per year as all Austrians together. And the carbon footprint is also not in favor of the digital currency. Bitcoin may appear golden to some - but it is definitely not green.

Moreover, it is questionable whether, when and, above all, which of the now numerous cryptocurrencies will and can ultimately establish themselves as a means of payment. Although acceptance has increased recently, the high daily volatility does not necessarily fulfill the criterion of a store of value. Especially since the intensifying efforts of important central banks in the direction of governmental cryptocurrencies may limit the long-term future fantasy for Bitcoin & Co.

This is a summary of our recent bitcoin longread. For the full text with further details and comprehensive explanations, please click here.