Thursday, 5 October 2017 Ryan Shea
Jamie Dimon hates it, Howard Marks doesn’t get it and Mike Novogratz thinks it is on its way to becoming “the largest bubble in our lifetimes”. As we have commented on before, love it or hate it (there seems to be little middle ground), the one thing you can say about Bitcoin’s price is that it moves… a lot.
Since September one could have looked at a screen and seen Bitcoin quoted at: USD 4,950, USD 2,952, USD 4,162 (at the time of writing) and almost everywhere else in between. This equates to annualized volatility of over 130%.
Extreme price swings (especially when in an upwards direction) tend to have the same attention-grabbing effect on investors as blood in the sea does on sharks. This has been true in Bitcoin’s case. However, another financial asset price has witnessed price gains of a similar magnitude in recent months without attracting anywhere near the same level of interest. And no, it’s not a little penny stock, but one that has a market capitalization of almost USD 400mn.
What is it?
Think of one of the safest “safe-haven” countries on the world.
Now, think of one of the safest institutions in such a country.
As surprising at it seems, the Swiss National Bank (SNB), which like a few other central banks is partly owned by private investors (40% in the case of the SNB), has seen its share price surge in the space of a few short months – see exhibit below.
Exhibit 1: SNB Share Price vs. Bitcoin Price
Bitcoin, and the block-chain technology it pioneered, are considered by many to be “game-changing” financial innovations so a modicum of crowd excitement and exponential price dynamics is understandable. But the SNB’s share price? A partly-government-owned central bank that has just celebrated its 110th birthday and whose operating practice has not radically changed in the recent past?!
In truth, no one – aside from the recent purchasers obviously – knows why the SNB’s share price has surged. (The stock is so far off-the-radar it has barely any news “liquidity” – certainly not enough for us to generate a crowd-sourced sentiment indicator). That said, some plausible theories have been proposed.
The first, is rising expectations that the SNB will follow the lead of the Basle-based BIS, who in 2001 bought out its private shareholders at a substantial premium (they paid CHF 16,000 – roughly double the prevailing market price). The problem with this explanation is why now? Some 16 years have elapsed since the BIS’s decision and there is no groundswell of public opinion pushing for such action. (SNB critics are more concerned with how it manages its bloated balance sheet – see below).
A second explanation, one we consider more compelling, is that investors are increasingly realizing that the SNB’s share price has very appealing debt-like characteristics and, as such, has been significantly undervalued.
After years of intervening to limit the CHF appreciation (including the introduction of a hard floor in EUR/CHF that was abandoned with spectacular market impact in January 2015) and in support of an accommodative domestic monetary policy stance, the SNB’s balance sheet has ballooned to almost CHF 800bn. This equates to more than 100% of Swiss nominal GDP, putting even the BoJ to shame. Of this total, 93% is held in foreign currency instruments.
Barring a substantial appreciation of the CHF, which the Swiss central bank is well-placed to stifle because of the ability to print its own currency, dividend payments look very coupon-like. Hence, so the argument goes, SNB shares are analogous to a government-backed perpetual bond which pays a nominal annual amount more than double the prevailing yield on a 10-year government bond, even taking into account the recent stellar appreciation of the share price.
With a float of only 100,000 shares SNB equities are clearly unsuitable for many investors, so why bring this up? Aside from pure interest’s sake (not many financial participants are aware that some central banks have publicly-traded stock) this episode brings to the surface issues that are more broadly relevant for investors, specifically about the relationship between price, its momentum and perceptions of an asset’s safeness.
For many Bitcoin detractors, it is a risky asset whose volatile price surge is the classic hallmark of a bubble. In support of this, a multitude of charts plotting Bitcoin’s price ascent versus other asset price bubbles have been produced. The more egregious examples (see below for a recent one) are when the x-axis is defined as days/months since the start of bubble, which typically put Bitcoin’s price either at an extreme high or very close to the peak of the prior asset bubbles.
Exhibit 2: A Recent Example
Source: (we are too polite to say)
Such analysis has embedded within it a deep hindsight bias. The previous bubble peaks were only identifiable ex post – there was no possible way to identify them ex ante, but by lining Bitcoin’s price up on the same chart this is exactly what is being done. Such comparisons are deeply flawed, although we admit they make for an interesting looking chart.
The critical “missing element” in determining whether an asset experiencing strong positive price momentum is in a bubble or not is where its price stands relative to its fundamental value. Bubbles can ONLY occur when prices exceed their fundamental values, below this level price gains (even if exponential) are just markets working efficiently (or super efficiently).
In the case of the SNB’s equity price, as we outlined above, there are solid grounds for considering the current level as not being overvalued (at least no more than the price of longer-dated Swiss government bonds). Hence, no bubble, notwithstanding its surging price.
For Bitcoin this is more challenging. Because it is so innovative, there is much more uncertainty regarding its fundamental or intrinsic value (not only in terms of the number, but also the valuation method). For the naysayers anything above 0 is overvalued, whereas for its proponents it could be worth up to USD 1mn. Our guess, and we acknowledge it is a guess, is that Bitcoin’s fundamental value lies around the USD 29,000 mark (we outlined the rationale in a Market Insight published earlier this year). Moreover, when we look at crowd-sourced sentiment towards Bitcoin it has been rising recently (positive sentiment momentum) but is far from extreme when compared with previous sentiment peaks. The absence of a strongly positive sentiment reading is important as it strengthens our conviction that Bitcoin is not in bubble-territory.
Exhibit 3: Crowd-Sourced Sentiment Vs. Price: Bitcoin
The recent moves in Bitcoin’s and the SNB’s share price also illustrate the deficiency of connecting an asset’s safeness with its price volatility. Typically, it is assumed that the lower the price volatility, the safer the asset. For example, cash is considered safer than government bonds, which in turn are considered safer than credit or equities. We are conditioned to think about an asset class as having specific safeness characteristics. Indeed, many asset allocations are based on this assumption. However, in the two examples above, both have experienced high price volatility, although most investors would judge the latter to be much safer than the former.
This is not just an intellectual point of curiosity; it has significant P&L implications. Failing to view an asset’s safeness as a dynamic not static property has proved costly in the past. Think back a few years ago. Investors worried about a repeat of the Great Depression were dumping global equities and scrambling into government bonds – an allocation shift that was supposed to make their portfolios less risky ie. safer. When central bankers finally grasped the policy “nettle” and implemented unorthodox policy tools – such as QE – equities rallied and government bond yields started to rebound.
Which was the safer asset at that point in time? An equity whose price had slumped by nearly 50% in a couple of quarters, or a government bond whose price had risen to record highs?
We think a much more robust approach is to consider an asset’s safeness as not being a fixed feature but one that can, and does, vary as a function of its price. Indeed, as many a credit trader knows…
“…there is no such thing as a bad asset, just a bad price”.
If this sounds a little at odds with how many investors have been taught to think about this issue, it may be worth recalling Benjamin Graham’s “margin-of-safety” principle as outlined in his famous book The Intelligent Investor first published in 1949.
Graham defines an investment’s safety margin as the difference between the underlying value (fundamental or intrinsic worth) and its price – the higher the former relative to the latter the higher the safety margin. Based on this definition it is not too far of an intellectual leap to conclude that an asset’s “safeness” critically depends upon its price and its intrinsic value, both of which vary over time.
Calculating, or more accurately estimating, intrinsic value is the bread-and-butter of value investors, but it is a far from simple exercise because of the high number of potential moving parts – both at the macro and micro level. As an additional cross-check, investors can also use crowd sentiment because emotions are the fuel that pushes asset prices away (either above or below) from their intrinsic value. Buying an over-valued asset in the hope of further price gains (ie. seeking to exploit bubble price-dynamics) may, or may not, be rational but it is a subjective not objective decision.
Indeed, Oaktree co-Chairman Howard Marks underlined the importance of sentiment when he said that…
If I could know only one thing about an investment I’m contemplating, it might be how much optimism is embodied in the price.”
“On the Couch”, Memo to Oaktree clients, January 14, 2016
Given that tracking crowd sentiment is our bread-and-butter, it should hardly be a surprise that we wholeheartedly concur with Marks on this point (if not on Bitcoin).
As supportive evidence of this viewpoint, consider the two following charts, which plot the one-year ahead change in relative total returns between the S&P500 and the 10-year US Treasury bond versus their respective crowd sentiments.
Exhibit 4: Crowd-Sourced Sentiment vs. Future Relative US Equity/Bond Performance
In the above charts the y-axis measures the difference between US equity sentiment (specifically the SP500) and in the absence of a crowd-sourced debt sentiment indicator our sentiment-based nominal GDP growth proxy inverted. On the x-axis we plot the one-year-ahead difference in equity/government bond total returns. Hence, a positive reading on the y-axis signifies the crowd is relatively more bullish on equities than bonds whereas on the x-axis it signifies an outperformance of equities relative to bonds. Both during the exceptional circumstances (hence the two different charts) of the Great Recession and in the period following there is a clear negative relationship.
In other words, relative crowd sentiment between equities and bonds generates a contrarian signal over a one-year return horizon. As occurred in the first few months of 2009, when equity sentiment was extremely bearish and bond sentiment extremely bullish, this warns that – at such points in time – equities are safer to own than government bonds. Not what you were taught at grad school, and not the strategy many investors implemented back then, but as hindsight shows, true nonetheless.
This is just one of many examples where we have shown that sentiment extremes generate contrarian signals about future returns – in fact, it underpins our concept of “crowd fail”, which we have discussed in previous Market Insights.
In our view, investors would be better-served by taking such elements into account and adopting a more flexible approach when thinking about an asset’s “safeness”. They would also be better-served by not making the assumption that exponential price dynamics automatically equates to a financial bubble. It does not.
(*) Many thanks to Frederic Georjon and Zhicheng Long at Infotrie for helping with the Bitcoin sentiment data.
Amareos sentiment analytics incorporate Thomson Reuters MarketPsych indices.
 Although he has had a slight shift in perspective since he first commented on Bitcoin in his Memo to Oaktree Clients – see: https://www.oaktreecapital.com/docs/default-source/memos/yet-again.pdf
 And, extending the analogy, often leads to a feeding frenzy.
 Another central bank that has private shareholders is the BoJ, a fact relatively unknown even in financial circles, but that has some significant policy implications as we discussed in a previous Market Insight – see: https://www.amareos.com/financialresearch/the-market-sentimentalist-monetary-delusions/
 Volume of online posts.
 Colloquially known as the central bank’s central bank.
 The exchange rate moved almost 30% after the peg was scrapped. A great example of where historic price volatility and investor perceptions of safety diverge – but more on that later.
 In terms of balance sheet expansion the BoJ has been no slouch – see: https://www.amareos.com/financialresearch/the-worlds-most-important-central-bank/
 Unlike the gold price, whose drop in 2013 put a CHF 15bn dent in the balance sheet prompting them to scrap the annual pay-out for the first time since 1991 when it was introduced.
 Since 1921, the SNB dividend has been set at a maximum of CHF 15 per share. Hence, rising profitability in the event of a weaker CHF cannot be the reasons for the share price rise.
 Presumably this is the reason why they were created in the first place, certainly it was not driven by sound analysis.
 See: https://www.cryptocoinsnews.com/bitcoin-will-hit-1-million-5-10-years-says-paypal-director/ . As an extreme upper limit, one could just about justify a USD 2mn valuation assuming that Bitcoin solely, and fully, replaces all of the USD 50-60tr in fiat monies around the globe. However, this is something that governments would never allow as maintaining control over the money supply and seigniorage are simply too attractive, not to mention other potential virtual currency players.
 In nominal terms cash has no volatility. One USD is one USD. However, because inflation rates tend not to be zero in real terms it does.
 Hat tip: MC.
 We covered his memo extensively in a previous Market Insight – see: https://www.amareos.com/financialresearch/just-one-thing-you-need-to-know/
 Our sentiment-based nominal GDP growth rate proxy is the equally-weighted sum of economic growth and future inflation sentiments. For further explanation of this indicator – see: https://www.amareos.com/financialresearch/the-market-sentimentalist-rear-window/ and https://www.amareos.com/financialresearch/caveat-venditor/
 For both periods, the correlation coefficient is around -0.53.
 And, please can we stop with the “scary” Bitcoin bubble price charts – fun to look at as they are.