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How a proxy investment portfolio reflects Bitcoin price fluctuations

By Aaron Brown

Now that the crypto market has recovered somewhat from the mid-June lows – which were now their lowest since 2020 – and volatility has eased, at least in terms of the already highly volatile crypto market, many investors are wondering whether the decline ” hit rock bottom” and is now behind us.

The forced deleveraging at the beginning of the month appears to be over, and the scattered crashes in various digital assets do not appear to have triggered an unstoppable cascade. Remaining investors appear to have the will to withstand further declines – should they occur – and the industry’s surviving organizations appear to be in fairly good shape.

Even if the worst is over, we don’t know if there will be a rapid recovery. It is recalled that after falling 50% from April to July 2021, prices quickly recovered to new highs, but after the crash that began in December 2017, it took more than two years before prices began to rise on a consistent basis .

The price of Bitcoin has soared and then crashed with great intensity impressively in recent years

Unknown “X”

Calculating a fundamental value for cryptocurrencies is impossible, as there are too many structurally unknown factors. We can, however, try to compare cryptocurrencies to other assets to see if they look undervalued or overvalued on a historical basis. I will only look at Bitcoin because it is the “steam engine” of digital currencies and has long served as a barometer for much of the cryptocurrency market. (p.s. I own Bitcoin and other crypto assets).

An important component of Bitcoin is a leveraged investment in technology. The same forces that drive profits for tech companies generally affect the financial success of cryptos, though not necessarily their fundamental utility, which is something entirely different. Crypto projects are definitely riskier than most tech stocks and far less well capitalized.

Bitcoin is also correlated with the price of gold. It is often assumed that the correlation must be positive, as both gold and Bitcoin can be used to store value unaffected by inflation and other currency problems, and are more easily transferable than dollars when sanctions become a problem.

In fact, there is a strong negative correlation if the relationship of the two is adjusted for other factors. Gold and Bitcoin are opposing solutions to the lack of faith in currency. Gold is simple and tangible and backed by thousands of years of history and not some newly invented theory. Bitcoin is complex and abstract, backed by 14 years of extreme volatility, and has great theory behind it. Gold does not require infrastructure. Bitcoin requires massive and global scale.

Bitcoin has also historically benefited from volatility in both tech stocks and itself. It’s not that investors like volatility and drive up the price as a result, it’s that innovation requires volatility to thrive.

Proxy portfolio

Four factors that “reflect” Bitcoin’s movements explain 88% of its price variation over the past four years, as shown in the chart below. An investment portfolio corresponding to one Bitcoin today consists of – in round numbers – $82,000 invested in the Nasdaq 100 technology index, with $21,000 in borrowed money and $50,000 in borrowed gold. So the value of this hedger today is $11,000, but we add $8,000 for the current level of the Nasdaq index and $6,000 for the value of Bitcoin volatility, to get $25,000, against a current market price for Bitcoin of about 20,000 $.

Before discussing what a “proxy” portfolio means, consider the chart. It shows that this portfolio has done a decent job of tracking Bitcoin prices since 2018. The one major deviation is the March 2021 boom, which was quickly followed by a crash, leaving Bitcoin in line with its historical relationships. prices.

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Correlation of Bitcoin price movements and proxy portfolio

Remember I’m not talking about fundamental value. It is possible that Bitcoin is worth twice the proxy portfolio or half or 10 times more or nothing. All we know is that current Bitcoin prices are about 20% below their historical relation to other market prices. If you believe that Bitcoin has been valued correctly on average over the last four years, then today it is cheap.

It’s easy to understand $82,000 in a Nasdaq portfolio, which means buying one Bitcoin is like putting $82,000 in tech stocks. If these stocks move up 10%, Bitcoin should rise by $8,200. If these stocks fall by 10%, Bitcoin will lose $8,200.

Lending $21,000 in cash and $50,000 worth of gold is also simple. Bitcoin is statistically a leveraged technology investment, so it is more volatile than the Nasdaq. If gold gains about 10%, Bitcoin will logically fall by about $5,000. If gold falls by about 10%, Bitcoin should logically see its value increase by about $5,000.

Volatility “plugins” are somewhat more complicated. Bitcoin has some option-like characteristics, so its price is higher when things are volatile. The current value of the Nasdaq index volatility add-on is $8,000. This means that if the volatility of the index increases by 50%, you can expect the price of Bitcoin to increase by about $4,000, while it will decrease by $4,000 if the volatility decreases by 50%. Bitcoin’s volatility premium is $6,000, so the corresponding numbers are $3,000 in gains or losses on the price of one Bitcoin if Bitcoin’s volatility increases or decreases by 50%.

Selection

This suggests that the decline in the price of Bitcoin, and possibly cryptocurrencies in general, was in line with expectations, given the collapse in tech stocks, as well as little change in gold prices and subdued volatility.

Going forward, Bitcoin looks attractive if you expect a rebound in the tech sector and flat or falling gold prices, plus a return to high volatility.

However, if you expect poor performance from tech stocks, soaring gold prices and reduced volatility, Bitcoin and cryptocurrencies are not for you.

Source: Bloomberg

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