April 27, 2021

Investment Theory

We’re All HODLRs Now

By Victor Haghani and James White 1

If you’ve been asking yourself the question: “To BTC, or not to BTC?” the market, in its infinite wisdom, may have just decided for you: we’re all HODLRs2 now, whether you like it or not.3

In a recent Bloomberg Odd Lots podcast interview with Joe Weisenthal and Tracy Alloway, Sam Bankman-Fried – 28-year old MIT grad, $10bb Crypto Whale and founder of FTX crypto exchange – explained a relatively new development in the relationship between Bitcoin and the stock market:

“If you rewind to 2018, you wouldn’t be sure whether stocks and crypto were positively or negatively correlated…[Some] people thought Bitcoin is the flight-to-safety asset – when stocks crash people would turn to Bitcoin – but others said it was a risk-on asset…Summary…wasn’t totally clear. Then after March 2020, [when Bitcoin and the stock market were both down big in the first two weeks of the month] now we know the answer. It’s clear that – at least right now – people see crypto as something with huge upside potential and the sort of the thing that does well in risk-on markets, not risk-off markets. Because when you’ve got a lot of money to play around with and you’re looking for something to do with it, something with huge upside sounds really appealing and you’re willing to take the risk that it goes to zero – but when everything is crashing and you’ve lost all your money, a lot of people are going to put it into what they think is going to be safe. That’s why the correlation [between equities and crytpo-currencies] has become really robustly positive.”

We took a look at the data, and they do support Bankman-Fried’s observations. From the start of 2018 until now, Bitcoin’s Equity Beta – the standard measure of the systematic, market risk of an individual stock – has been 1.0.4 By contrast, in the early days of Bitcoin, from 2014 to the end of 2017, it was only 0.3, with extended periods when it behaved like a safe-haven asset, going up when the stock market was falling.5 This was consistent with the popular “digital gold” view of Bitcoin – a protection against a meltdown of the Western financial system. Meanwhile, real, shiny gold exhibited an Equity Beta of -0.2 and 0.2 over the same two periods, and as you’d expect, generated a much lower return as well.

From a purely statistical perspective, the last three years of data is telling us that if we wake up a year from now – or a month from now, the way things have been going – and Bitcoin has quadrupled to $200,000, the odds would be heavily in your favor to guess that the stock market will have gone up in value too – although far less than fourfold. Similarly, if Bitcoin collapses to $2,000, it’s pretty likely – as a matter of statistical inference – that the stock market will be lower. This argument doesn’t depend on knowing the direction of causality (if any) between changes in the stock market and Bitcoin. In fact, our best guess of what’s going on is that both the stock market and Bitcoin are being driven by some common forces, rather than Bitcoin driving price action in the stock market or the other way around.

As Bitcoin has gotten bigger, more widely-held and more integrated into the global financial system, it has been behaving more and more like a stock – a big, techie, super-volatile stock – and likewise, some stocks have been acting a little more like crypto-currencies. Here’s Bankman-Fried in the same interview, this time on how stocks are starting to behave more like coins:

“In the last year, equities have started to look more like crypto. You look at GameStop…There’s a word for it in crypto, it’s called a ‘shit-coin.’ The beautiful moment of this [was] when RobinHood banned the buying of GameStop…GameStop crashed…They stopped buying GameStop and they bought what is in retrospect the only possible answer to this question. They bought Dogecoin! As soon as GameStop started crashing, Dogecoin ten-x’d [went up tenfold]. Absolutely beautiful!”

Depending on your outlook, there are varying implications of Bitcoin’s current incarnation as a risk-on asset.

  • If you think the expected return on Bitcoin is close to that of the stock market, you may want a small holding – Bitcoin’s current size relative to the global equity market is about 1%, and the total digital coin market amounts to a bit under 2% – just as you would want to own all the stocks in the market portfolio. However, many investors, ourselves included, feel owning the global stock market through low cost, liquid index funds and ETFs provides sufficient diversified exposure to risk-on assets, and don’t feel the need to own all the other assets that don’t come with a global stock market index fund.
  • If you think the expected return is significantly higher than that of the stock market, then a more substantial holding would be consistent with that view.
  • However, if you think it has an expected return lower than that of the stock market, as would be typical of a safe-haven asset, then you probably don’t want to own any of it: with a Beta of close to 1, it’s not offering the risk-mitigation to warrant the lower return.6 Even if you’re more worried about inflation than financial crisis risk, we suspect that owning a combination of inflation-protected Treasury bonds (TIPS), real estate and equities,7 might be a better way to get the job done.
  • Finally, for those who are outright bearish on Bitcoin and its brethren, the higher correlation between the stock market and Bitcoin might be the canary in the coal mine – a warning that we should not expect the stock market to be unconnected to swings in the crypto-currency markets. Thinking back to the buildup to the dot.com crisis and the subprime mortgage debacle, many market observers (your authors included) wrongly believed that the broad stock market would be minimally affected by a crash in these relatively small pockets of speculative fever, as each amounted to roughly 4% of global stock market capitalization.8 Currently, Bitcoin, other digital coins and related businesses are about 3% of the size of the stock market.

While we agree with Sam Bankman-Fried that, currently, Bitcoin is mostly behaving like a risk-on, speculative asset, we also recognize that it has gone through many rebirths and transformations. In early November 2020, Odd Lots co-host Tracy Alloway made the most cogent case we’ve heard for why we should expect the Bitcoin narrative to continue evolving, which will force investors to reassess its place in the matrix of investment choices:

“I have a confession to make: I am now bullish on Bitcoin. I’m bullish on Bitcoin because I’m bullish on cognitive dissonance in a complex society, and on people’s ability to produce endless narratives for cryptocurrency – even ones that are, at times, contradictory. Since its creation back in 2009, Bitcoin has been lauded and promoted as so many things. It’s a method of payment (you can buy pizza!) but it’s also a speculative financial asset whose value is destined to go up (so you should save it!). It’s a hedge against inflation (because central banks are printing money!) but it’s also a financial asset that benefits when interest rates are close to zero and there’s less opportunity cost to hold it (it’s digital gold!). Bitcoin is a way of disintermediating the existing financial system (because you can’t trust the bank!), but it’s also something that would benefit from a flood of institutional money (asset managers are diving in!).”

  1. This not is not an offer or solicitation to invest, nor should this be construed in any way as tax advice. Past returns are not indicative of future performance.
    Thanks to Simon Bowden, Richard Dewey, Costas Kaplanis, John Karubian and Ricky Moezinia for their suggestions.
  2. According to Investopedia.com:
    “HODL is a term derived from a misspelling of “hold” that refers to buy-and-hold strategies in the context of bitcoin and other crypto-currencies.”
    More recently, it’s been used as an acronym for “Hold On for Dear Life,” in recognition of the wild ride that most crypto-currency investors experience.
  3. Not that you’ll find Bitcoin has magically appeared in your brokerage account, although for every $1,000,000 invested in the broad US stock market, you own over $100 of Bitcoin through your ownership of Tesla (TSLA), Microstrategy (MSTR) and Square (SQ), and another $2,000 or so in crypto-currency focused companies such as Coinbase (Coin).
  4. Note that a Beta of 1.0 does not imply a correlation of 1.0. Highly volatile assets can have a high Beta with a low correlation. βi = ρi,m σi / σm , where i refers to the asset whose Beta we are measuring and m refers to the broad stock market.
  5. Beta measured using weekly overlapping weekly returns for the S&P500 and Bitcoin from 9/30/2013 to 4/19/2021.
  6. Another serious challenge to the notion of Bitcoin as a safe-haven asset is the fact that under most plausible assumptions, the combination of a low expected return, high volatility, and a conviction that its price cannot go below zero, results in a strong downward drift in the expected median value of Bitcoin over time.
    For example, with Bitcoin’s 85% annual volatility and a 0% expected return, the median price of Bitcoin in four year’s time would be about 80% lower than today’s price. This effect is known as “volatility drag.”
  7. For example, German equities actually increased in value in US dollars through the hyperinflation experienced from 1921 – 1923, while all nominal claims were essentially wiped out. See “The Economics Of Inflation – A Study Of Currency Depreciation In Post War Germany”, by Costantino Bresciani-Turroni, 2008.
  8. Total loss of value in dot.com companies was estimated at $1.7 trillion, with stock market capitalization around $38 trillion (Wikipedia: Dot-com bubble). Subprime mortgage market at its peak was $1.3 trillion (Wikipedia: Subprime crisis background information), and the global stock market was $40 trillion.