JPM on why Bitcoin will go to $146k, halve, or both

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Macro Afternoon

JPM:

The virus crisis, by boosting money supply as well as demand for an “alternative” currency, has supported both gold and bitcoin over the past year. The older cohort preferred gold, while the younger cohorts preferred Bitcoin as an “alternative” currency. Both gold and bitcoin investment vehicles have experienced strong inflows over the past year, as both cohorts saw the case for an “alternative” currency. This simultaneous flow support has caused a change in the correlation pattern between Bitcoin and other asset classes, with a more positive correlation between bitcoin and gold but also between Bitcoin and the dollar (Figure 1). In addition, the simultaneous buying of US equities and Bitcoin by millennials has increased the correlation between bitcoin and S&P500 since last March, so it is more appropriate to characterize bitcoin as a “risk” asset rather than a “safe” asset, also given its still very high 70% realized volatility. To some extent, this is also true with gold. Gold’s correlation with the S&P500 has been predominantly positive over the past year and its volatility at close to 20% is more similar to that of equities than to currencies or bonds (Figure 2). In other words, both bitcoin and gold could be more characterized as “risk” rather than “safe” assets based on their behavior over the past year and investors’ preference for them is likely more of a reflection of a need for an “alternative” currency rather than a need fora “safe” asset or “hedge.”

In the second half of 2020, Bitcoin started receiving more support via corporate adoption, initially with Square and MicroStrategy and last October with Paypal. Paypal’s adoption of Bitcoin was a big step toward corporate support for Bitcoin, which in turn appears to have triggered demand for bitcoin by institutional investors such as family offices, hedge funds and even insurance companies such as MassMutual. Some of that institutional impulse into Bitcoin likely came at the expense of gold based on the more than $4bn of inflows into the Grayscale Bitcoin Trust and the more than $7bnof outflows from Gold ETFs since mid-October (Figure3). There is little doubt that this competition with gold as an “alternative” currency will continue over the coming years given that millennials will become over time a more important component of investors’ universe and given their preference for “digital gold” over traditional gold. Considering how big the financial investment into gold is, any such crowding out of gold as an “alternative” currency implies big upside for Bitcoin over the long-term. As we had mentioned previously in the Oct 23rdFlows & Liquidity, “Bitcoin’s competition with gold,” private gold wealth is mostly stored via gold bars and coins, the stock of which, excluding those held by central banks, amounts to 42,600 tonnes or $2.7trn including gold ETFs. Mechanically, the market cap of Bitcoin at $900bn currently would have to rise by 3x from here, implying a theoretical Bitcoin price of $146k, to match the total private sector investment in gold via ETFs bars and coins.

We mentioned previously this long-term potential upside based on an equalization of the market cap of Bitcoin to that of gold for investment purposes is conditional on the volatility of Bitcoin converging to that of gold over the long term. The reason is that, for most institutional investors, the volatility of each asset class matters in terms of portfolio risk management, and the higher the volatility of an asset class, the higher the risk capital consumed by this asset class. Thus, it is unrealistic to expect that the allocations to Bitcoin by institutional investors will match those of gold without a convergence in volatilities. A convergence in volatilities between Bitcoin and gold is unlikely to happen quickly and is in our mind a multi-year process. This implies that the above $146k theoretical Bitcoin price target should be considered as a long-term target, and thus an unsustainable price target for this year. In fact, an argument can be made that, in terms of risk capital, Bitcoin has more than equalized with gold already. To see this, one could compare the volatilities of Bitcoin and gold, or the volatilities of the biggest Bitcoin and gold funds given many institutional investors are only allowed or prefer to invest in fund format. The 3m realized vol for Bitcoin currently stands at 87% vs. 16% for gold. In other words, the ratio of the two vols suggests that Bitcoin currently consumes 5.4x more risk capital than gold. This ratio rises further if one looks at the biggest Bitcoin and gold funds. The 3m realized vol for the Grayscale Bitcoin Trust stands at 113% vs. 16% for GLD, the largest gold ETF by AUM, i.e., the ratio of the two vols suggests that the Grayscale Bitcoin Trust currently consumes 7.1x more risk capital than GLD. Taking the average of the 5.4x and 7.1x ratios, suggests that Bitcoin and its biggest fund on average consume 6.2x more risk capital than gold and its biggest fund, double the 3x ratio needed to equalize the market cap of Bitcoin ($900bn) to that of gold for investment purposes ($2.7trn). In other words, Bitcoin, at current market prices, has already more than doubled relative to gold in risk capital terms. In our opinion, unless bitcoin volatility subsides quickly from here, its current price of $51k looks unsustainable. In fact an argument can be made that the $25kprice that equalizes Bitcoin with gold in risk capital terms could be considered as an upper bound of its fair value range as this price already frontloads (at current levels of volatility) any long-term upside for Bitcoin stemming from real money institutional adoption.

What about the lower bound of its fair value range? In our opinion one way of thinking about the lower bound of its fair value is based on the mining cost or intrinsic value of Bitcoin. The ratio of the bitcoin market price to its intrinsic value is shown in Figure 4. The current ratio is higher than its previous mid-2019 peak and matches its end-2017 peak, again raising concerns about valuations. This is not to say that the mining cost is driving the market value. The opposite is likely true. In the early years, Bitcoin’s production cost had naturally stronger influence on the price because new coin generation was a higher percentage of existing stock or supply. Now that more than 18.6mn Bitcoins have been mined already (vs.max supply of 21mn) and new coin generation is a smaller percentage of the existing supply, the influence of the production cost on the price has likely diminished. Thus, in the current conjuncture, the market price is likely driving the production cost rather than the other way round. However, this causality does not mean that the Bitcoin price would be diverging from its mining cost on a sustained basis. Similar to gold, when the bitcoin market price is well above the production cost, mining activity and mining difficulty should increase, pushing the cost of production up towards the market price, thus inducing some convergence. But similar to previous episodes, some of that convergence could happen with an adjustment in the market price also. We thus view the acute divergence of Figure 4 as another valuation challenge for bitcoin and the current mining cost of $11kas a lower bound of its fair value range.

 

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